We can buy fire insurance tomorrow Remember the Great Moderation, those sunny days of fun and laughter before the Great Recession stomped into town and set fires everywhere? Imagine if old Uncle Bernanke and his canasta partner Mr Monti didn't have that hose handy..? Well, Goldman Sachs have taken a look at just how far memories have faded by the way that disaster risk is now priced. It may be that the US was singed first, but it is far more relaxed than Europe. The overall return to moderation, however, is not yet complete. We find that, leading up to and during the crisis, much of the build-up in risk premia can arguably be traced back to intensified perceptions of disaster risk. By many metrics (EUR/$ options, sovereign yield spreads, equity skew, volatility "smiles," among others), a significant part of these premia has also come out of the market, contributing to a rebound in asset values. But some of that risk perception lingers above pre-crisis levels. There is no salesman you can ask for the price of compressive financial calamity insurance, so what Goldman use as a proxy for the cost of disaster risk are a variety of indicators: Exhibit 1 shows one of the key metrics related to Euro area concerns: the skew in EUR/$ options (the difference in implied volatility between out-of-the-money and at-the money options, a reflection of investors" concerns of sharp falls in the price of the underlying asset). During the first decade of the monetary union, skew hovered closely around zero. But it spiked during the sub-prime crisis in the US, and then shot even higher in 2010. It then remained at very high levels until ECB President Draghi's "whatever it takes" speech in the summer of 2012. That speech had a profound impact on the alleviation of perceptions of disaster risk in Europe, with the skew in EUR/$ options declining by more than a third. It now sits close to its lowest level in four years, but it is still substantially higher than before the sovereign debt crisis erupted. This adds to the abundance of new year then and now charts. To pick a couple from the presentation this week by Jeffrey Gundlach of Doubleline. US high yield pricing: And European sovereign spreads (click to enlarge): But the Goldman team also note some continued weirdness in option pricing, with long-dated "smirking" in the volatility curve more pronounced than the short end, which has returned to its normal but not in line with theory weirdness. Or as they write with far greater clarity: An important component of the evolution of disaster risk relates to how the pricing of extreme outcomes changed (or not) with the crisis. To assess that, we look at volatility skew in options markets (see The Buzz, "A round trip for the VIX driven by policy uncertainty," October 10, 2013). The traditional model of options pricing predicts constant volatility at every strike price, but Exhibit 9 illustrates that SPX options show a different pattern. Unlike the theory, which assumes a log-normal distribution, the presence of disaster risk leads to more volatile out-of-the-money puts (on the left of the at-the-money strike) than out-of-the-money calls (on the right of the at-the-money strike). So, in practice, volatility varies by strike, leading to curved lines that oftentimes trace out a "smile." In addition, as the chart shows, the whole curve shifted upwards in the late 1990s and early 2000s - after LTCM, the Asian financial crisis and the dot.com bust. As had happened with the 1987 crash, this reminded markets that negative tail events do occur and should be accounted for. One symptom of heightened concerns about rare disasters would then be a volatility smile that is even more "lopsided" than usual (higher left-hand side). The period 2007-2011, which included the US sub-prime crisis and the Euro area crisis, entailed a similar upward move of the implied volatility curve from its relatively more tranquil levels in 2003-2006 (Exhibit 10). The increase in curvature during the 2000s revealed the well-known volatility "smirk" in equity options. What is interesting for our purposes here is that, at low strike prices, the curve in 2012-2014 looks very much like it did before the crisis (in 2003-2006). In that sense, markets have gone back to pricing negative tail events almost the same way as they did before. Part of that has to do with the alleviation of disaster risk perceptions, but it also has to do with recent trend of using at the-money calls as leveraged alternatives to buying stocks. By contrast, the more pronounced "smirk" coming from higher volatility in out-of-the-money calls may respond to perceived upside on the back of the recovery. And these patterns not only apply to the US, they are also visible for the FTSE and Nikkei, among other markets. They note, however, that there is evidence of a deeper shift in currency markets, with a more pronounced smirk in the USD/EUR cross. For those interested, they point to the paper crash risk in currency markets for work which suggests the asymmetry has increased more for the higher interest rate currencies. There is also more in the usual place. Related Links: Tapering, dealer inventory and bond market liquidity - FT Alphaville Crash test dummies and fund manager surveys - FT Alphaville "Price is not destiny" - FT Alphaville Vol nightmares unrealised, for now