Lesson 13 of 25 · 7 min

What an inverted volatility term structure indicates

A downward slope is a dated forecast that the stress will end, and the date and the number can both be read off.

An inverted structure is one where near-dated implied volatility sits above far-dated. Take illustrative figures: one month 41.3 percent, three months 33.8 percent, twelve months 26.4 percent. The curve slopes down instead of up.

What that shape encodes is a near-term episode plus a return towards ordinary conditions afterwards. It is not merely a mood — the expectation is quantified, and lesson 12's method extracts it. Between one and three months the forward volatility is 29.34 percent, and between three and twelve months it is 23.42 percent.

So the curve is making three statements in sequence: 41.3 percent for the coming month, 29.34 percent for the two after that, and 23.42 percent for the following nine. That is a dated forecast of calming, with prices attached to each segment. It is the clearest quantitative statement of mean reversion in volatility available anywhere, and it is sitting in the quoted numbers rather than in anybody's commentary.

What inversion does not tell you is whether the near-term figure is correct. Inverted structures have preceded episodes that resolved within weeks and episodes that got substantially worse. The shape is a price, and Track 3 lesson 9 was clear that a price is not a prediction anyone has committed to.

The collateral consequence is about which point gets read. Feed the one-month figure into the model with a 3.5 multiple and a 15-session exit and the haircut is 35.27 percent, an advance rate of 64.73 percent. Feed the twelve-month figure into the same model and the haircut is 22.54 percent, an advance rate of 77.46 percent. A 12.72-point spread in the advance rate, from the same surface on the same afternoon, decided by which column a model was built to read.

Key terms

Inverted term structure: Near-dated implied volatility above far-dated. It prices a near-term episode followed by a return towards ordinary conditions.
Mean reversion in volatility: The tendency of volatility to return towards a longer-run level. An inverted curve is that tendency with dates and numbers attached.
Anchor point: The expiry a model reads its volatility input from. On an inverted curve the choice of anchor moves a haircut by double digits.

Worked example

Reading an inverted curve, then pricing collateral off it

Illustrative implied volatilities: one month 41.3 percent, three months 33.8 percent, twelve months 26.4 percent. Haircuts use a 3.5 multiple and a 15-session exit.

Forward volatility, months two and three: 29.34%
Forward volatility, months four to twelve: 23.42%
Haircut from the one-month point: 35.27%
Haircut from the three-month point: 28.86%
Haircut from the twelve-month point: 22.54%
Spread across the three anchors: 12.72 points

One surface, three defensible haircuts, a 12.72-point spread. The borrower's advance rate depends on a modelling convention they cannot see.

Check yourself

One-month implied volatility is 41.3 percent and three-month is 33.8 percent. What is priced for months two and three, and what does the inversion say?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.