School of business - research
The market is down 10%? No worries, I'm insured!
We often think of financial intermediaries processing the buy and sell orders of their clients in a calm manner, much like air traffic controllers allocating airport spots to incoming and departing planes. Similarly, just as the technical problems faced by air controllers can cause your flight to be delayed, the constraints affecting financial intermediaries may impact the performance of your portfolio.
In a new paper1, professors H. Chen, S. Joslin and Sophie Xiaoyan Ni demonstrate how the trading patterns of deep out-of-the-money put options on the S&P 500 index (DOTMSPX, the rough equivalent of an insurance against market crashes) reflect financial intermediaries constraints and may be used to predict excess market returns across a range of financial assets.
Thrilled when markets soar, investors know a crash might be just around the corner and, just like we buy travel insurance, seek protection against a sudden market contraction. One way of doing so is to buy DOTMSPX, which gives buyers the right to sell back the option at a guaranteed price upon its expiry.
The study uses the amount of DOTMSPX that investors buy monthly (PNBO) – roughly equivalent to the amount sold by financial intermediaries over the same period – as a proxy for the crash insurance market. Although PNBO levels fluctuate widely and may even turn negative during periods of market distress, financial intermediaries are generally net sellers of PNBO. Thus, a low PNBO can only occur either when investors are not looking to buy crash insurance or when financial intermediaries are unwilling to supply the market. But how can we differentiate between these two situations? By looking at DOTMSPX prices.
Periods during which both PNBO and the price of DOTMSPX (as measured by the variance premium) increase happens when both investors and financial intermediaries are active DOTMSPX traders: as the market goes up, more investors buy DOTMSPX to protect themselves while financial intermediaries, flush with liquidity and able to hedge their positions, are keen to meet demand.
On the other hand, periods during which DOTMSPX prices are rising but PNBO goes down occur when financial intermediaries are reluctant to sell and may even become – such as in the months following the Lehman Brothers bankruptcy in 2008 – net buyer of DOTMSPX. This situation reflects the new constraints financial intermediaries must prioritise – such as stricter regulatory requirements (Dodd-Frank Act, Basel III), losses, inability to hedge etc. – before resuming their normal activities.
Interestingly, this tightening of intermediary constraints is also associated with rising risk premiums across many financial assets, deterioration in funding liquidity and the deleveraging of broker-dealers. The study also shows that a low PNBO associated with financial intermediary constraints can predict that the market will generate excess returns averaging more than 4% over the next few months, as investors demand extra returns to compensate for their inability to buy crash insurance.
So next time you are dismayed at the value of your portfolio or upset that your flight has been delayed, don’t shout at your financial advisor or at the pilot before knowing for sure it’s their fault!
Reference:
1Chen, H., Joslin, S., & Ni, S. X. (2019). Demand for Crash Insurance, Intermediary Constraints, and Risk Premia in Financial Markets. Review of Financial Studies, 32(1)), 228-265.