Wednesday, April 9, 2014
Ulric B. and Evelyn L. Bray Seminar
Demand for Crash Insurance, Intermediary Constraints, and Stock Return Predictability (joint with Hui Chen and Sophie Ni)
Scott Joslin, Assistant Professor of Finance and Business Economics, USC Marshall School of Business
The net amount of deep out-of-the-money (DOTM) S&P 500 put options that public investors purchase (or equivalently, the amount that financial intermediaries sell) in a month is a strong predictor of future market excess returns. A one-standard deviation decrease in our public net buying-to-open measure (PNBO) is associated with a 3.4% increase in the subsequent 3-month market excess return. The predictive power of PNBO is especially strong during the 2008-09 financial crisis, and it cannot be accounted for by a wide range of standard return predictors, nor by measures of tail risks or funding constraints. Moreover, periods of low PNBO are also associated with steeper slopes of the implied volatility curve and smaller growth in broker-dealer leverages. To explain these findings, we build a dynamic general equilibrium model in which financial intermediaries play a key role in sharing tail risk. The time variation in the intermediary constraint drives both the equilibrium demand for crash insurance and the market risk premium. Our results suggest that trading activities in the crash insurance market is informative about the degree of financial intermediary constraints.