Editor’s Letter

So the policy “debate” (or perhaps “debacle”?) continues in Washington, with the “sequester” that began in March. The sequester is an arbitrary reduction in government spending by over $1 trillion over the next several years, beginning with $85 billion in the remaining seven months of the current fiscal year. The cuts must be proportional across the board, greatly limiting the ability to prioritize spending reductions. Looking back at my most recent Editor’s Letter, in the Spring 2013 issue of The Journal of Derivatives, I was observing that the obviously unsettled and uncertain state of the U.S. and world economies did not seem consistent with the unusually low level of implied volatilities in the options markets. I hypothesized that no matter what the various factions in Congress might be threatening to do at any particular point in time, the market must be assuming they would continue to avoid really bad decisions in the end, probably sidestepping them at the very last second as usual.

Unfortunately, this has turned out to be a misjudgment. Everyone regards the sequester is as a really bad policy, which is appropriate given that it was originally designed to be a really bad policy—so bad that the Republicans and Democrats would surely have to agree to some better way to handle things before the sequester actually took effect. It is estimated that the sequester will take about 0.6% out of GDP growth this year, roughly $100 billion from a $16 trillion economy. Somehow Congress prefers this outcome to working with the other side to do something better.

Along with the sequester, there’s the perennial favorite battle over raising the “debt ceiling” to allow the Treasury to borrow the money it needs to pay for the spending Congress has already authorized. This will probably come up some time in September. Reports are already circulating that another big fight is being planned.

And let’s not even begin to think about Cyprus. Or unemployment in the Eurozone. Or…

But in the options world, the VIX volatility index, often known as the investor “fear gauge,” has gone down from where it was in February, to an extremely low 12.6%, which is well under its long-term average of over 20%.

Given that your editor clearly has no clue about what conditions will frighten investors and provoke volatility, we had better turn to something he understands better. The current issue of The Journal of Derivatives starts off with two articles on options with American exercise. In the first, Klein and Yang explore the early exercise decision for the holder of an American call that is exposed to counterparty credit risk. Unlike the standard case, in which early exercise can be optimal only for a dividend-paying underlying stock just before it goes ex-dividend, it can be optimal to exercise a vulnerable option for credit reasons at any point in time, even with a nondividend paying underlying. This substantial change in exercise strategy leads to differences in the value of a vulnerable American call that earlier pricing approaches on do not properly capture. In the second paper, Chung, Shih, and Tsai consider American barrier options. Determining the optimal exercise strategy is a challenge for these contracts, and delta hedging carries the familiar problems of tracking error and transactions costs. The authors develop a static hedging strategy using a portfolio of plain vanilla options that is cheaper and easier to implement. Remarkably, the static hedge also has substantially lower tracking error than delta hedging.

One of many changes to normal operating procedures in the financial world after the crisis of 2008 has been the shift in the over-the-counter (OTC) market for swaps and other interest rate products from LIBOR to overnight indexed swap (OIS) rates for discounting future cash flows. LIBOR is used as a measure of the (essentially) risk-free rate of interest, but 2008 revealed that banks borrowing at LIBOR were less risk-free than one would have liked, and more recently, attempts to manipulate the market by reporting incorrect LIBOR rates have recently come to light. OIS is the average overnight rate paid in the Federal funds market, which is more transparent, and more risk-free than LIBOR is. Smith explains the change to OIS discounting and shows how big valuation differences may be.

Usually we hear skeptical nonfinance people asking: “What are all these derivative things good for anyway? Why do we need them?” For a financial theorist, the tone of the question may seem a bit rude, but the issue is a real one. In the models we use for pricing options, they are redundant securities. In theory, there is no reason for options to exist, since trading between the underlying stock and bonds can produce the same payoffs. Tan builds a theoretical model to show how calls can be valuable even in a highly stylized world under assumptions that would typically make them redundant. It is the embedded leverage that makes calls useful tools for optimally managing lifetime consumption. Finally, like Chung, Shih, and Tsai’s work, our last paper is also concerned with barrier options, but from a quite different perspective. Buesser is interested in using such options to explore investors’ beliefs about the underlying processes driving exchange rates. Payoffs on one-touch options depend on the path followed by the underlying, not particularly on the terminal value. He finds that the return dynamics that give the best fit for vanilla options prices are considerably different, and more complex, than those the market appears to use in pricing one-touch contracts.

As depressing as the situation in Washington may be, your editor is soon to be distracted by a major biological event that is even worse: 17-year cicadas. Those who may not be familiar with this peculiar race of insects can google the term and read their bizarre story. Briefly, these are the longest-living insects in the world. They live underground as a kind of beetle for 17 years, then all at once billions emerge from the earth, break out of their shells, and turn into enormous red-eyed flying insects that fill the air. A few weeks later, after mating, they all die, leaving behind a nasty odor of decaying bugs. Seventeen years ago, my family learned, to our horror, that a vast flock of these insects live under our house in New Jersey. They are getting ready to come out, so by the time you are reading this, they are probably all over me every time I step outside my door.

I would almost rather be in Washington—except that the cicada problem will be gone in a couple of months. If only that were true of Congress!

TOPICS: Options, counterparty risk, statistical methods

Stephen Figlewski

Editor

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