Asia is less skewed than the west, at least in terms of equity volatility

Volatility skew is a somewhat technical concept I worked with every day on Wall Street trading desks before 2009, but here I hope to explain the concept as non-technically as possible for a general investor audience, at least those familiar with options and/or statistics. “Volatility skew” for investors generally refers to a measure of the balance between small and frequent moves in one direction averaged out by large and rare moves in the other.  An index with an equal chance of moving +1% or -1% on any given day could be said to have zero skew.  A high-yield bond is a classic example of negative skew: say there is a 90% chance the bond is paid in full plus 12% interest vs a 10% chance the bond defaults and loses 70% of its value.  Lottery tickets on the other hand are an extreme example of positive skew. Traders are generally less interested in this backward looking statistical measure of returns, and by “volatility skew” usually mean implied volatility skew – the difference in the relative price of an out-of-the-money put option vs. an equally out-of-the-money call option.  As an example, AUD/JPY and other “yen carry” pairs typically show a negative implied skew because the market expects carry trades are quite likely to post small and frequent positive returns (making AUD calls / JPY puts relatively cheap), but with a chance  of a large and rare negative return in a market panic.  A more “pedestrian” analogy is probably to think of insurance: it is more likely and more devastating that a Japanese house will be destroyed in an earthquake and lose 50% of its value over the next year than it is that the same house will increase by 50% or more in value over that same year, so insuring against earthquake damage will have a noticeable cost, while buying a 50% out-of-the-money call on the house would probably be much, much cheaper. I found the need to dust off this topic after years becoming less technical because of an observation I heard at a Bloomberg seminar about a month ago that, despite being off Bloomberg these days, I could not resist trying to verify:

In the West, skew tends to be negative due to a”fear and greed” mindset: investors buy puts for protection in down markets and write calls for yield enhancement in up markets.

In Asia, equity returns are positively skewed for the opposite reason: investors sell puts when the market dips, and pile in to buy calls while the market rallies.

Said another way, western investors tend to oversupply calls and overdemand puts, creating a negative skew where downside protection costs more than upside “protection”.  Eastern investors on the other hand seem more likely to oversupply puts (whether to “buy low” or “sell into a volatility spike”) in down markets relative to overdemanding calls (often as warrants) in up markets, making skew more positive than in the west.  By many accounts (before my option trading career), between the dawn of listed options on CBOE in 1973 and the crash of 1987, western index options showed no volatility skew but rather traded on a flat Black-Scholes volatility across strikes,  and only after the crash of ’87 did traders suddenly start paying up for downside protection.

I could not get good data on implied volatility skew in different markets, especially not historically, so resorted to a quick and dirty calculation of historical skew based on historical prices:

[Source: Yahoo! finance, skew calculated on monthly returns]

This is not the best chart for telling a clear story of skew, but there are a few noteworthy points to read out of it:

• Between 1995 and 2008, Asian indices (smooth lines) were consistently less negatively skewed than western indices (dotted lines).  Before 2005, the Hang Seng and Straits Times index returns were both positively skewed, as was the Nikkei before 2000.
• Since the chart is of 60-month rolling skew (shorter periods were too noisy), between September 2008 – September 2013 the skews all seemed to converge in a tighter negative range, but this is mostly because all these indices faced similar large declines after the Lehman collapse.
• The last data point for each index is hard to see on the chart, but is the first 60-month period after but not including September 2008, which calculate as:

1. Nikkei (N225) = -0.137
2. Hang Seng (HSI) = +0.056
3. Straits Times (STI) = +0.900
4. S&P 500 (SPX) = -0.447
5. FTSE 100 = -0.172
6. Swiss Market Index (SMI) = -0.388

By this very crude measure at least, it does seem to be true that equity returns do tend to be positively skewed in Hong Kong and Singapore while still being less negatively skewed in Japan than in major western markets.