Stock options offer window into bank performance

Can bank stock options tellus about the future of the economy? The answer, based onrecent research from “Financial Sector Tail Risk and Real Economic Activity:Evidence from the Option Market,” is ‘yes’, writes Professor Michael Newmann of the School of Economics and Finance at Queen Mary, University of London.

The financial sector isdifferent from other sectors in the economy in that failure of financialinstitutions can induce significant negative externalities. Banks and financialfirms more broadly provide services that are vital to the functioning of thereal economy.

The health of the financialsector and its related ability to carry out these tasks therefore likely playsan important role in determining real economic activity. Consequently, highfinancial sector tail risk today should be related to low real economicactivity tomorrow.

While tail risk—or the risk of an asset or portfolio ofassets moving extraordinarily far away from its current price—can be eitherpositive or negative, most practitioners are concerned with negative tail risk.Negative tail risk, in particular, can affect the role of the banking sector inthe economy as it signals that banks are in trouble.

Optionmarkets are an ideal venue for learning about the dynamics and predictive powerof financial sector tail risk for several reasons. At any point in time theoptions can offer insights into market participants’ expectations on how goodor bad things could be in the future. With puts basically acting as ‘insurance’against a ‘bad’ or negative future state of the world, the bank stock optionsmarket offers information on what may be happening in the financial sectorgoing forward at any given time.

Moreover,put options with strike prices far away from the current level of theunderlying asset price (DOTM put options) can be viewed as explicit bets on, orinsurance against, lower tail outcomes and consequently can track the market’sassessment of the likelihood and severity of future tail events. By looking atbank stock put options, advisors and others can thus gain insights, not justinto the options market itself but also links between financial sector tailrisks and the real economy.

Withthe ‘telling’ nature of the options market, bank stock options should beinformative about the likelihood of future severe disruptions in the financialsector.  When the banking sector islikely to face distress in the future, banks will not lend as freely, in turn,adversely affecting economic activity and growth going forward. It follows thathigh option market-implied financial sector tail risk should be able toforecast low future economic activity.

Thestudy’s results confirm that financial sector tail risk estimated from pricesof traded bank stock options predicts future real economic activity. Thisfinding is illustrated in Figure 1. The figure plots the level of the NationalActivity Index published by the Federal Reserve Bank of Chicago in one month againstthe option market implied level of financial sector tail risk in the previousmonth over the period 1996 to 2012.

Onecan see a clear negative relationship as indicated by the downward slopingtrend line. That is, high option-implied financial sector tail risk today tendsto be followed by low economic activity tomorrow. The paper shows that asimilar predictive relationship also holds for various alternative indicatorsof real economic activity such as industrial production growth and changes innon-farm payroll employment.  The assertionsfrom the paper are backed up using equity volatility surface data obtained fromthe IvyDB US Options Database from OptionMetrics, containing option prices andsmoothed volatility surfaces for all US options starting from 1996.

Theseresults highlight the attractiveness of option markets in the context offorecasting real economic activity and monitoring financial sector stress.

Optionprices are readily available at any point in time and consequently real-timemeasurement of aggregate financial sector tail risk based on them isstraightforward. This is strikingly different if compared to tail riskindicators estimated on historical data. Tail risk outcomes are naturally rareso assessing their likelihood based on historical tail event realisations isimprecise.  By nature, options areintrinsically forward-looking instruments; their value explicitly depends onthe payoff they may generate in the future. Therefore, options may anticipatechanges in the likelihood of tail events much quicker and more accurately thanbackward-looking tail risk indicators. 

Optionmarkets provide real-time aggregate financial sector tail risk information thatis related to future economic performance. As such, investors, advisors, and policymakersshould keep a close eye on the option market.