Risk versus Uncertainty

Most of us don’t know the difference between risk and uncertainty.  Risk is the uncertain outcome of known future events, or “unknown known.”  Uncertainty, instead, is the uncertain outcome of unknown future events, or “unknown unknown.”

A good example is that you need to decide when to leave home to pick up someone from the airport.  On average, it takes you, say 40 minutes, to drive to the airport.  You figure you will give yourself an extra 10 to 20 minutes more, depending on the time of day, traffic, weather, etc., so you will not “risk” missing your pickup.  But when you go to the garage 60 minutes before the scheduled arrival time, and found out your car won’t start.  AAA won’t come for at least an hour, so you will miss the pickup.  Case in point, whether to leave home 60 or 70 minutes before the arrival time is the “risk” you can take.   The car battery died on you is the “uncertainty” that you didn’t expect.

Generally, financial market is efficient in pricing in risk.  A typical example is that the volatility rises approaching to the public news announcement, such as Fed interest rate changes, company earnings releases, and drop off immediately after the announcement.  Sometime, the volatility will drop even prior to the actual announcement of the news, if the news announcement is widely anticipated.

On the other hand, the market is usually clumsy in dealing with uncertainty.  Immediately after the internet bubble busted in 2001, the housing market bubble in 2008, and most recently, the Brexit vote, the financial markets were utterly blind sighted.

After all, how would you price something that you don’t know it even exists yet?

This gives us a potential framework to explain a seemingly anomaly in today’s options market.  Russell Rhoads showed a very interesting case in implied volatility (IV) in the S&P options around the election date.  He found that, others things being equal, the IV, or VIX, is around 10 for the options expired immediately before the election date versus 12 for the options expired after the election date.  This is both surprising and intriguing.  Since based on conventional wisdom, the VIX should drop after the election date because the election result is known and the risk is eliminated.

There can be two rational explanations. One is that although the election (risk) is over, another risk will emerge if Trump is not the winner, which is more likely the case by the poll numbers.  As he has “primed” the public that he may not accept the result.  This known, non-acceptance, risk will drive up the volatility into the future.

Another possibility is that the post-election uncertainty arises because nobody, including Trump himself, knows how he will deal with a defeat.   At the end of the third presidential debate, Trump said, “I will keep you in suspense.”

Either way, it appears that options market rationally priced in “the non-acceptance risk” or “uncertainty of suspense” in the post-election period.

 

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