This paper provides evidence that demand for equity index options has predictive power for
future volatility beyond current and lagged volatility in publicly available data. The predictive power increases prior to macroeconomic announcements and exhibits a positive relation with investor uncertainty about macroeconomic news. Straddle positions that trade on the volatility informed index option demand yield annualized Sharpe Ratios that are up to twice as large as the Sharpe Ratios on a long index investment. Sharpe Ratios increase with the amount of volatility informed trading in the options market. In times of high volatility, the demand for
straddle positions contains significantly more information and has an impact on option liquidity levels.
Uncertainty pervades most aspects of life. From selecting a new technology to choosing a career, decision makers rarely know in advance the exact outcomes of their decisions. Whereas the consequences of decisions in standard decision theory are explicitly described (the decision from description (DFD) paradigm), the consequences of decisions in the recent decision from experience (DFE) paradigm are learned from experience. In DFD, decision makers typically overrespond to rare events. That is, rare events have more impact on decisions than their objective probabilities warrant (overweighting). In DFE, decision makers typically exhibit the opposite pattern, underresponding to rare events. That is, rare events may have less impact on decisions than their objective probabilities warrant (underweighting). In extreme cases, rare events are completely neglected, a pattern known as the “Black Swan effect.” This contrast between DFD and DFE is known as a description–experience gap. In this paper, we discuss several tentative interpretations arising from our interdisciplinary examination of this gap. First, while a source of underweighting of rare events in DFE may be sampling error, we observe that a robust description–experience gap remains when these factors are not at play. Second, the residual description–experience gap is not only about experience per se but also about the way in which information concerning the probability distribution over the outcomes is learned in DFE. Econometric error theories may reveal that different assumed error structures in DFD and DFE also contribute to the gap.
In this paper we study risk and liquidity management decisions within an insurance firm. Risk management corresponds to decisions regarding proportional reinsurance, whereas liquidity management has two components: distribution of dividends and costly equity issuance. Contingent on whether proportional or fixed costs of reinvestment are considered, singular stochastic control or stochastic impulse control techniques are used to seek strategies that maximize the firm value. We find that, in a proportional-costs setting, the optimal strategies are always mixed in terms of risk management and refinancing. In contrast, when fixed issuance costs are too high relative to the firm’s profitability, optimal management does not involve refinancing. We provide analytical specifications of the optimal strategies, as well as a qualitative analysis of the interaction between refinancing and risk management.
Previous psychological investigations revealed that sacred values (SVs; the belief that certain values are nonsubstitutable and may not be traded off, in particular, against secular economic values) modulates moral decision making depending on the type of SV infringement involved. Extending this research, we compared neurofunctional correlates determined from fMRI measurements during decision making in 3 different trade-off types (taboo, tragic, and routine) with psychological measures obtained from the same 2 participant groups characterized by either high SV (SVH) or low (SVL)scoring values. Congruent with previous studies showing that outright SV violation tends to provoke profound moral indignation, in accordance with the surmise that SVs serve as a heuristic under these (taboo trade-off) conditions, and in conformity with previous reports on neurofunctional changes observed in volunteers confronted with moral norm transgressions, we found increased blood oxygenation level-dependent (BOLD) signals in the left anterior temporal lobe and bilateral amygdalae, as well as significant correlation between right amygdala BOLD signals and moral disgust ratings, in the taboo trade-off condition for the SVH (compared with the SVL) group. The results are discussed in relation to previous research suggesting a close association of SVs with a deontological focus of moral universalism, as well as regarding mechanisms supposed to play a key role in overcoming barriers to the resolution of deep-seated conflicts.
In a model where banks play an active role in monitoring borrowers, we analyze the impact of securitization on bankers’ incentives across different macroeconomic scenarios. We show that securitization can be part of the optimal financing scheme for banks, provided banks retain an equity tranche in the sold loans to maintain proper incentives. In economic downturns however securitization should be restricted. The implementation of the optimal solvency scheme is achieved by setting appropriate capital charges through a form of capital insurance, protecting the value of bank capital in downturns, while providing additional liquidity in upturns.
This paper combines the concept of market sidedness with excess option demand (changes in open interest) to solve the empirical challenge of separating directional from uninformed trading motives in widely available, unsigned options data. Our measure of options market sidedness persistently predicts the sign and strength of stock returns. Trading strategies conditional on the measure are highly profitable. For instance, when the measure indicates positive (negative) information, out-of-the-money calls (puts) generate returns of 27% (32%) over roughly four weeks. Risk-adjusted returns of a long-short equity strategy yield more than 2%. An increase in directionally informed demand predicts a decrease in option liquidity and increases in pricing inefficiency.
