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While most might count Frank Knight's tutelage of four future Nobel laureates as his greatest accomplishment, his own work on uncertainty and risk may prove the most applicable in understanding the current global economic environment. While his top University of Chicago students would go onto greater acclaim; Milton Friedman (monetarism, consumption analysis, monetary history), Ronald Coase (a theorem on economic allocation amidst externalities that would bear his name), George Stigler (regulatory capture) and James Buchanan (public choice theory), it is Knight's work on economic risk that best describes the distinguishing features of this crisis forty years after his death. In his seminal work, "Risk, Uncertainty and Profit," Knight differentiated between economic risk and uncertainty, which are often viewed synonymously. The former, economic risk, is a situation where the outcomes are unknown but governed by probability distributions known at the outset where decision makers can work towards maximizing expected utility. Uncertainty is characterized by random outcomes and, unlike risk, is immeasurable.

The economic outcome in Europe, and resultantly for global growth generally, is a "Knightian Uncertainty." Three years into the sovereign debt crisis on that continent, the only thing that appears certain is that this story will play out over many more years. The key decision makers driving the outcome will continue to change driven by the mood of their respective electorate, morphing the ultimate solution and the time it takes to reach its outcome. Market pressures on embattled sovereigns and their financial institutions will be met with policy prescriptions that markets hail as a panacea, but undoubtedly stressors will again heighten as the road to closer economic and fiscal integration will be traversed by a Northern and Southern Europe driven further apart by market realities.

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While financial journalism keeps the European quagmire at the forefront, one of my favorite recent articles about the economic uncertainty in Europe did not feature the word "Europe" at all. Peter Orszag, former director of the Office of Management and Budget, published an article on Bloomberg entitled: "Bad Models Mistook Housing Bust for Dot-Com Bubble." In the article, he explained why even though the dot-com bust and housing meltdown began with losses of equal magnitude, the housing crisis spawned such a deeper and widespread downturn. Both private and public sector economists misjudged the economic impact of the housing driven downturn because they underestimated the stress in the financial industry's impact on the real economy.

In my day-to-day job running institutional fixed income portfolios, I am forced to be keenly aware that the securities I buy - corporate bonds, asset and mortgage-backed securities, municipal bonds, and government bonds - are all different mechanisms of channeling credit to businesses, households, and governments. Thinking about the consequences of an economic recession can not begin with a top down view about how credit spreads on my holdings will widen as a result of a recession. If spreads widen enough, then a negative feedback loop through the broader economy is created, exacerbating the downturn. This is the scenario that is taking place in Europe, tying Orszag's article about the two most recent domestic recessions to the situation abroad. The continent's financial system holds copious amounts of government bonds in part driven by the incentives of the former regulatory regime for these institutions to hold them. These banks are being encouraged by the European Central Bank to purchase even greater quantities of sovereigns through the LTRO. The outcome for a country's sovereign debt will of course affect the financial health of that country's financial system. Economists and markets have historically poorly priced the impact of financial market stress on asset prices and real economic growth. The impact from a fallout is today immeasurable - a Knightian uncertainty indeed.

While we are reaching into the annals of economic theory to shape our thoughts of the current market environment, a fifty-year old idea in the field of finance may also have merit. In 1963, Benoit Mandelbrot observed that "large changes tend to be followed by large changes of either sign, and small changes tend to be followed by small changes." The idea, known as volatility clustering, has been proven mathematically given that while returns themselves are uncorrelated, their squares display a positive, statistically significant, autocorrelation function. You don't need the math to understand that big spikes in asset prices tend to be followed by more big spikes in asset prices. Given the continued economic uncertainty emanating from Europe and her fragile financial system, one should expect to see continued uncertainty.

This missive is not a directionless history lesson, it comes with a simple edict. Europe is not well defined by probabilistic scenarios. The outcome is very uncertain, and this difference between risk and uncertainty should alter how market participants behave accordingly. The uncertainty in the financial sector, given its role in channeling credit to the economy, can give us more disparate outcomes than even renowned economists believe are possible. Volatility tends to cluster and the large swings in asset prices are likely to continue for better or worse. However, the market is going to provide you an opportunity to cost effectively hedge your downside, you just need to seize it.

The market prices risk and uncertainty. The most common tool is the VIX index, or "fear gauge", which measures the stock market's expectation of volatility over the next thirty days through options on the S&P 500 (SPY, IVV). From 1990 to today, the average level of the VIX index has been just over 20. Just ten trading days before Lehman Brothers filed the largest bankruptcy in U.S. history, the VIX index closed at 19.43. The VIX index would hit 80.86 one month later. Despite being less than six months removed from the Bear Stearns crisis, the market was implying volatility at its historical average in late August of 2008. In reality, the S&P 500 would shed nearly half its value over the next five months.

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The VIX index would close the first day of July 2011 at 15.87. Despite being one month from when the United States was expected to breach its debt ceiling, unleashing uncertain consequences on financial markets, the VIX index was pricing an annualized percentage change of 15.87%, or dividing by the square root of 12, that over the next one month roughly a 2/3 chance that the market would end in a range of just 4.58% from the current level. The S&P 500 would fall dramatically over those next three months, from its close of 1340 on July 1st to its 2011 low of 1099 on October 3rd.

There are five main components that drive the value of an option: the current price of the underlying, the strike price or level at which the option will be exercised, the time to expiration, the volatility of the stock price, and the risk-free discount rate. A put option gives the buyer the right, but not the obligation, to sell the stock at the strike price at some date in the future. Today, market participants can buy a three month put option on the S&P 500 with a strike price 10% out of the money for roughly 2% of notional (pre-market $2.55/$121 on SPY ETF). We buy insurance in many aspects of our lives. With the markets bouncing off their recent lows, spurred by the bank rescue in Spain, and volatility receding, the market looks like it will provide another opportunity to add some insurance to your portfolio at its average cost over the last twenty years. If the situation in Europe feels like above average risk (or uncertainty), take the opportunity to buy some insurance. I hope we will not need it, but uncertainty, especially in the financial sector, is immeasurable, and volatility tends to cluster.

Source: Knightian Uncertainty, Volatility Clusters And Europe