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Decimal Digest
29 Mar 2011

Market Estimation of Timing of the Euro Crisis

Of the entire list of black swan events that have been hitting the financial markets since the unexpected Jasmine Revolution in Tunisia, the steady built up in the tempo of banking-sovereign debt problem in the Eurozone periphery is the least unexpected event. Exactly when, or if at all the debt problem will cause a turmoil in the financial markets is a matter of speculation.

One analytical framework is to look at the yield curve of various sovereign issuers in the Eurozone, and look for a hump in a certain maturity. An unusual hump will indicate market’s estimate of increased chance of default of that particular sovereign around that maturity. Many analysts in the market follow this method.

However, Eurozone, by design, is a queer place. It has many sovereigns under one unified currency. The above analytical framework does not indicate the market expectation of impact of default of a peripheral sovereign on the broader Eurozone financial markets.

Hence, we at Decimal Point have developed an analytical framework to look at market estimates of immediate volatility as compared to long term volatility. The chart below shows, on an inverted scale, 21-day moving average of the ratio of 24-month sub-component of VSTOXX to 3-month sub-component of VSTOXX.

The above chart lends to some interesting interpretations. While the market expected an immediate crisis (rising line in the chart) in April-June 2010 period, the market was not expecting an immediate blow up as recently as late February 2011. However, since last few weeks, the market’s expectations of a Eurozone-wide turmoil occurring in the immediate future have risen sharply. We need to wait and watch if the political machinations in the Eurozone can avert a Eurozone wide crisis, which the market thinks maybe around the corner.


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