Have equity investors become more risk-tolerant?

The Economist points out that the use of margin has reached new heights.

Margin debt in the American stock market has reached a new record of $285bn. In other words, more borrowed money is being used to buy shares than ever before.

(Somewhat portentously, this article was written a couple of weeks before the recent tumult felt in global equity markets.)

The article identifies low volatility as one reason why margin debt might be increasing. (Low volatility implies lower risk and hence higher prices; hedge funds that normally thrive on volatility using leverage to enhance returns; and banks' VaR models showing that it's safe to deploy higher amounts of capital based on current levels of volatility.) It then goes on to say:

 

It is worth noting, however, that all three factors could be subject to quick revision. If volatility rises, shares will look riskier. Hedge funds will be tempted to cut their borrowings, and investment banks their trading positions. This could cause a sharp correction, as investors all try to head for the exits at the same time.

Until such an event occurs, the circle is virtuous. Low volatility props up markets, which keeps volatility low. What is needed for the circle to turn vicious is a trigger. So the bears are dependent on a satan ex machina―a huge corporate default, a geopolitical risk come true, or a bird-flu epidemic―to turn sentiment around.

However, when I first read the article (before the recent bout of volatility), it occurred to me that this low volatility combined with higher levels of leverage might not be as house-of-card-ish as one might initially think. Why? Because of the phenomenal growth in derivatives for hedging purposes. Could it just be that low volatility and high debt are sustainable simply because investors are better hedged against the causes of volatility than they ever were? Now, I know that hedging is still a zero-sum game, but if hedging brings in new participants who would not otherwise participate in the equity markets and also takes into account risks not previously considered, then surely the equity market system is deeper, more liquid and more stable than before?

Link: Market.view | Buy now, pay later | Economist.com

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