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Janette Rutterford, focusing on the case of Long-Term Capital Management, examines the changes in valuation techniques and how the increased use of hedge funds have contributed to the current volatility of financial markets
THIS AUTUMN, the financial markets have been through turbulent times. Political unrest in Russia and, more importantly, the Russian government's default on certain government bonds, has triggered substantial falls in global stock markets. The Russian stock market itself was down 79% in October 1998 from its peak one year earlier (see Figure 1 on over leaf for the stock market index since February 1998). The US and European markets have also fallen - as much as 23% and 25% respectively from their July 1998 peaks. But they have since recovered somewhat and are, in any case, at historically high levels. Even Russia is only down 28% on a two-year perspective.
However, market volatility has certainly changed. Typically, market volatility for developed stock markets measured in standard deviation of annualised returns - hovers around the 15 to 20% mark. In recent bull markets this has been even lower. For example, in the US, the first quarter of 1998 showed 30-- day volatility below 10%.
This autumn, 30-day volatility is running at above 40% in the Standard & Poor 500. Russia is again breaking records with 30-day volatility at 192%. It is this kind of volatility, in bond and equity markets worldwide, which has led to the demise of one of the largest and most respected of investment or 'hedge' funds, Long-Term Capital Management (LTCM), and major losses by a number of global banks.
This article concentrates on two aspects of market volatility: how valuation and changes in attitude to valuing companies have contributed to the 'frothiness' of the market, and the role of the new investors of the 1990s - the banks and the so called `hedge funds' in all this.
Value is in the eye of the beholder
You can value companies and shares in a wide variety of ways - from looking at the assets on the balance sheet, through applying common market multiples like dividend yield, P/E or price-to-book ratios, right through to discounted cashflow techniques. Not so many decades ago, equities were viewed like bonds, and valued...