Updated with data through February 20, 2014
February 20, 2014 [PDF]
Banks and insurance company equity prices generally recovered some of the declines posted prior to our last report. The stock performance was relatively weak, however. CCAR banks trailed the S&P 500 by about 300 basis points and insurance companies trailed by about 100 basis points. Nevertheless, tail risks, as measured by RNPD standard deviations, fell in both groups as spot prices rose.
There was little change in RNPD statistics related to future inflation and LIBOR rates. One year inflation expectations derived from caps and floors remain centered near 2%. Short-term LIBOR rate expectations derived in a similar manner continue to indicate upward bias.
Banks & Insurance Companies
Option trading on bank stocks was light last week but active for insurance company stocks. Options on AIG, MET, and ALL traded well above recent averages. Skews in both groups continue to trend higher while RNPD standard deviations fell in excess of 100 basis points, on average.
Other Commodity Markets
RNPD standard deviations generally fell and spot prices generally rose across the range of additional commodity markets we follow. Trading activity was mixed. We noted high levels of volume in options on precious metals futures and dollar-pound exchange rate futures.
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Large changes in asset values or commodities prices can be associated with significant changes in economic output and price and financial stability. For that reason, policymakers seek to monitor market concerns about extreme movements—so-called tail events—in key asset and commodities markets. The prices of options to buy (“call options”) or sell (“put options”) assets or commodities in the future at specified prices (“strike prices”) provide valuable information about potential tail events. The prices of call and put options with differing strike prices can be used to estimate a probability density function of the payoff of the underlying asset or commodity.
In this report, we use options prices to produce what are known as “risk-neutral probability density functions” (RNPDs) for future asset and commodity values. Interpreting RNPDs can be subtle, because they combine both investors’ expectations of the future price of the traded asset or commodity and the compensation they received for taking on related aggregate economic risks. The changes over time in RNPDs that we show reflect changes to both of these components, and decomposing the change into the constituent parts is not possible without making additional strong assumptions. Nonetheless, we regard the RNPDs shown here as valuable barometers of financial market sensitivity to possible extreme movements in the prices of key assets and commodities.
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The exhibits contained in this report show density functions at three different points in time, allowing viewers to see how risk-neutral expectations of market participants have evolved over time. Specifically, we think it isuseful to examine the following characteristics within each exhibit and note how they have changed over time: