Monday, March 31, 2014

Your whole perspective gets hazy

So you turn to options markets during times of political uncertainty, say Bryan T. Kelly, Lubos Pastor, Pietro Veronesi, to determine what to do, what to do;
Equity markets are an informative gauge of the price of political uncertainty. They reveal investors' assessments of how political risks impact economic activity into the indefinite future, conveniently summarised in present value terms. Day after day, stock prices react to news about what governments around the world have done or might do.
How to measure that?
Options are ideally suited for this analysis for two reasons.
  • First, they have relatively short maturities, which we can choose to cover the dates of political events. An option whose life spans a political event provides protection against the risk associated with that event. Since the political event is often the main event that occurs during the option’s short life, the option’s price is informative about the value of protection against political risk.
  • Second, options come with different strike prices, which allow us to examine various types of risk associated with political events, such as tail risk.
We find that at-the-money options whose lives span political events are on average 5% more expensive than neighbouring options that don't span the event. Furthermore, the well-known implied volatility smirk dramatically steepens around such events as investor demand for insurance against tail events soars. For example, among put options that are 10% out-of-the-money (and thus provide better protection against tail risk than at-the-money options), options whose lives span political events are more expensive by 16% compared to neighbouring options. We also find that political events are associated with abnormally high variance risk premia, so that insurance against variance risk is also more expensive ahead of such events. 
Politicians are expensive;
We show that political uncertainty commands a risk premium, especially when the economy is weak. By raising the firms’ cost of capital, political uncertainty depresses investment and real activity. Furthermore, by raising risk premia, political uncertainty destroys market value. Perhaps we should ask reckless politicians to chip in. 
Or come up with better ways to control how large a role politics plays in our lives.

1 comment:

  1. Politicians and their staffs front-run regulatory and policy changes. Maybe they are also buying into the options markets.