Wednesday, January 22, 2014

Option Markets Price Political Uncertainty And Raise Put Option Prices From 5 To 16 Percent

From National Bureau Of Economic Research, NBER Working Paper Series, "The Price Of Political Uncertainty: Theory And Evidence From The Option Market" by Bryan Kelly, Lubos Pastor, and Pietro Veronesi, Working Paper 19812:
[O]ne-month at-the-money put options whose lives span political events tend to be more expensive by about 5.1% compared to neighboring options. Implied volatilities are particularly high shortly before pivotal events such as the 2008 U.S. presidential election and the 2012 Greek election, both of which took place during major financial crises. The positive average slope means that investors value the protection that deep-out-of-the-money put options provide against the tail risk inherent in political events. For example, among one-month puts that are 5% out-of-the-money, options whose lives span political events are more expensive by 9.6% compared to neighboring options, on average, while among options that are 10% out-of-the-money, they are more expensive by 16.0%. The average variance risk premium is also positive, 0.0107 per year, implying that insurance against variance risk costs significantly more ahead of political events.
To summarize our empirical results, we find that political uncertainty is priced in the option market. Option protection against three types of risk associated with political events—price risk, tail risk, and variance risk—is more valuable when the economy is weaker as well as when the uncertainty is higher, consistent with the theory. Our results survive several robustness tests, including placebo tests designed to detect any relations between option prices and economic conditions that are unrelated to political uncertainty.

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