China Volatility Reaches New Highs

While most China pundits focus on the dramatic drop in prices on the Shanghai Composite Index (SSE), I haven’t seen any comments on volatility.  The annualized volatility measured by a conditional volatility model is hovering around 60%.  The average annualized volatility for this index going back to January 2001 is 12% so this is quite an increase.

I downloaded daily returns from Yahoo Finance for the index from 1990 to July 28th this year.  There were many non-trading days when the index did not change or the numbers were not reported and I eliminated them.  Curiously the price for July 8th this year was missing but I found it using a Google search.  I ended up with 3,527 trading days of data.  I calculated the continuously compounded returns.  On a Daily basis they look like this:

 

Volatility is sticky; that means that when an event occurs, volatility tends to remain for a while before it dies out.  One graphical technique to look for volatility clustering is to square the returns.

The above chart shows definite clustering in 2002, 2008-2009, and this year.  Also statistical tests indicate that volatility changes over time.  Another way to look at these returns is to use a histogram and I show the results below.

The return on July 8th was -6.08% which was the 18th worst daily return. This was actually below the first percentile.  The worst return occurred on February 27, 2007, and was -9,26%  The return on Monday of this week was -8.87%, the second worst day.  When the Chinese government imposed restriction, the return on July 10th was 4.44% – the 99th percentile.  On the 29th the market was up over 3%.  In the space of three weeks the SSE has gyrated from the worst returns to the best returns.

I used a conditional volatility model that takes into account asymmetric volatility clustering.  I used R to calculate the daily variance and then transformed this into daily annualized standard deviations.

The latest volatility reading is 57% which is about as high as during the financial crisis of 2008 – 2009.  Markets can be fickle, even with governmental imposed constraints and it looks like volatility in China will be with us for a while.

The downward plunge in the SSE has some strategic implications for the government.  The unwritten promise that the communist party has made with the people goes something like this: we will let you get rich but don’t push for democracy.  Since most of the investors are retail customers, and if this downward trend continues, is this promise broken?