Can bank stock options tell us about the future of the economy? The answer, based on recent 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 is different from other sectors in the economy in that failure of financial institutions can induce significant negative externalities. Banks and financial firms more broadly provide services that are vital to the functioning of the real economy.

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

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

Option markets are an ideal venue for learning about the dynamics and predictive power of financial sector tail risk for several reasons. At any point in time the options can offer insights into market participants’ expectations on how good or 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 options market offers information on what may be happening in the financial sector going forward at any given time.

Moreover, put options with strike prices far away from the current level of the underlying asset price (DOTM put options) can be viewed as explicit bets on, or insurance against, lower tail outcomes and consequently can track the market’s assessment of the likelihood and severity of future tail events. By looking at bank stock put options, advisors and others can thus gain insights, not just into the options market itself but also links between financial sector tail risks and the real economy.

With the ‘telling’ nature of the options market, bank stock options should be informative about the likelihood of future severe disruptions in the financial sector.  When the banking sector is likely to face distress in the future, banks will not lend as freely, in turn, adversely affecting economic activity and growth going forward. It follows that high option market-implied financial sector tail risk should be able to forecast low future economic activity.

The study’s results confirm that financial sector tail risk estimated from prices of traded bank stock options predicts future real economic activity. This finding is illustrated in Figure 1. The figure plots the level of the National Activity Index published by the Federal Reserve Bank of Chicago in one month against the option market implied level of financial sector tail risk in the previous month over the period 1996 to 2012.

One can see a clear negative relationship as indicated by the downward sloping trend line. That is, high option-implied financial sector tail risk today tends to be followed by low economic activity tomorrow. The paper shows that a similar predictive relationship also holds for various alternative indicators of real economic activity such as industrial production growth and changes in non-farm payroll employment.  The assertions from the paper are backed up using equity volatility surface data obtained from the IvyDB US Options Database from OptionMetrics, containing option prices and smoothed volatility surfaces for all US options starting from 1996.

These results highlight the attractiveness of option markets in the context of forecasting real economic activity and monitoring financial sector stress.

Option prices are readily available at any point in time and consequently real-time measurement of aggregate financial sector tail risk based on them is straightforward. This is strikingly different if compared to tail risk indicators estimated on historical data. Tail risk outcomes are naturally rare so assessing their likelihood based on historical tail event realisations is imprecise.  By nature, options are intrinsically forward-looking instruments; their value explicitly depends on the payoff they may generate in the future. Therefore, options may anticipate changes in the likelihood of tail events much quicker and more accurately than backward-looking tail risk indicators. 

Option markets provide real-time aggregate financial sector tail risk information that is related to future economic performance. As such, investors, advisors, and policymakers should keep a close eye on the option market.