Value at Risk
Periods of low volatility tend to encourage risk-taking. Hedge funds have a natural inclination to buy higher-yielding (and thus riskier) instruments and sell low-yielding assets, since this delivers a positive income or “carry.” When the market falters, these positions rapidly lose money. For example, the modest rise in the yen — 2.3% against the dollar on February 27th, 2007 — wiped out about half the annual interest gain accruing to investors who sold yen and bought dollars.
Investment banks use “value-at-risk” models which mean that, when volatility rises, they cut the capital they allocate to trading. This usually means selling assets. So a sudden jump in volatility tends to generate further volatility.
What matters is how many actors have all made the same bet. One of the oldest market mistakes is the assumption that you can get out of a position as easily as you entered into it. According to Goldman Sachs, the latest jump in the Vix (a measure of stockmarket volatility) took it eight standard deviations from its average. If conventional models are correct, such an event should not have happened in the history of the known universe. Then again, the move in energy prices that caused the collapse last year of Amaranth, the hedge fund, was a nine standard-deviation event.
“Grey Tuesday,” The Economist