Mounting Volatility, Risk Management and the Fear Index: Why Financial Institutions Should Care

Introduction

The crash of the Nikkei index on 5 August 2024 – the biggest since 1987 – and the global sell-off that followed it have underscored just how volatile stock markets have become. To identify risks at an early stage, prevent losses and take their chances, players are increasingly looking at sentiment and fluctuation indicators such as the CBOE Volatility Index (VIX), also known as the “fear index”. Based on gauges like the VIX, market participants are reviewing and updating their risk management.

Volatility Drivers

Volatility has risen alongside the largely politically driven exacerbation of the vulnerability of both the global economy and the biophysical environment on which it depends. A surge in geopolitical tensions, wars, terrorism, natural disasters and pandemics like Covid -19 has put global supply chains including energy resources under unprecedented strain. Escalating risks have heightened uncertainty, spurring market participants’ nervousness, which reflects in more volatile prices.

Another factor that impacts investor behaviour is central banks’ monetary policy. Interest rate hikes, whether upwards to curb inflation or downwards to stimulate the economy, usually lead to falling or rising stock prices respectively. Last but not least, investor expectation and, consequently, market volatility tend to react to economic indicators such as GDP growth, inflation rates or employment statistics.

Gauging Investor Fear

From stock option prices, the CBOE Volatility Index calculates the fluctuation range of the S&P 500 for the next thirty days. The VIX is regarded as indicative of investor sentiment on the entire US stock market. As it mirrors market stress, it is also known as fear index or fear gauge . Banks and other financial service providers look to it as it correlates with stock market returns. Thus it serves as a leading indicator for market players to readjust their risk management.

Volatility in Check

In the financial sector, an essential hazard is credit risk – the danger that borrowers might default on all or part of their debt. Market risk materializes when an asset loses value due to rising inflation, for instance. Liquidity risk increases when many clients withdraw their deposits at short notice, making it more difficult for the bank to service its liabilities. In addition, institutions operating internationally need to manage foreign exchange (FX) risks.

Quantifying risks like the above is quite a challenge; minimizing them requires a set of well-matched measures. A common method comprises periodic stress tests based on extreme but plausible scenarios such as sharp rises in interest rates, legislative changes, pandemics, natural disasters or geopolitical tensions. To hedge against FX or interest rate risks in particular, derivatives like options or futures provide a flexible approach.

Lately, tech companies catering to the financial sector have launched machine-learning AI apps that help market players analyse big data for risks and trends in real time, comply with regulatory requirements and sustain the market’s unrelenting pressure for maximum efficiency. Given that such systems are bound to be state of the art among competitors soon, investing in them has become imperative.

Your Ally in Risk Management

By providing holistic, bespoke solutions, Consileon enables financial service providers to master market volatility and keep risks under control. Among other things, we build a smart surveillance system that constantly tracks and evaluates risks relevant to your lines of business. Based on your criteria, our automated „Lighthouz“ test suite thoroughly examines the output of all your AI services including those employed in risk management. We analyse and document IT architectures complete with interfaces to detect any need for action in internal or downstream systems at an early stage.

Detection and prevention matrices tailored to your business draw your attention to underrated risks before any damage occurs. Our real-time dashboard helps managers make well-founded decisions even when time is scarce. We support your projects to ramp up your volatility and risk management all the way from strategizing to organizational and technical implementation, and on to integration in your live systems. Detailed checklists provided by Consileon make it easier for you to future-proof your IT.

In a Nutshell

Given a perilous combination of mostly politically and ecologically driven megatrends, the current financial market volatility is more likely to increase than remain episodic. To stay competitive, banks and other financial service providers must face this uncertainty, measure the risks, keep them from materializing and prepare for worst cases. By setting up an agile, holistic, state-of-the-art risk management function, market players can boost their resilience and hold their own even in difficult times.