Avoid Buying Put Insurance When You are Most Afraid
Last updated on January 18th, 2017 at 03:00 pm
A timely piece on S&P 500 put option prices. The authors find that S&P 500 put options get too expensive during wild times because of 2 effects:
- Demand for insurance sky rockets (investor utility demands safety)
- Supply for insurance becomes restricted (credit constraints cripple market makers)
The lesson seems to be straight forward: buy insurance when you don’t “feel” like you need it; avoid buying insurance when you “feel” like you need it (ie. insurance prices can become more expensive–and move away from theoretical prices–in market downturns).
We document that the skew of S&P500 index puts is non-decreasing in the disaster index and risk-neutral variance, contrary to the implications of no-arbitrage models. Our model resolves the puzzle by recognizing that, as the disaster risk increases, customers demand more puts as insurance while market makers become more credit constrained in writing puts. The skew steepens because the credit constraint is more sensitive to out-of-the-money puts. Consistent with the data, the model also predicts that the skew is increasing in the broker-dealers’ liability-to-asset ratio; and the net buy of puts is decreasing in the disaster index, variance, put price, and liability-to-asset ratio.
Here are the theoretical IV Skew and Disaster Index results:
And here are the empirical results:
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