Monday, October 16, 2006

Implied probabilities

I was expecting a bigger negative correction in Korea indices from the recent nuclear test. The KOSPI index trades at a price/earnings discount of a factor of about 1.5 compared to US equities (current iShares MSCI S. Korea index has a P/E of 11.3), and not so long ago the discount was a factor of 2. I thought a big chunk of that was geopolitical risk due to N. Korea, but after the recent test there was only a small 3-4 percent correction. On the other hand, it seems to be almost business as usual on the Korean peninsula, so perhaps markets knew better than me what the consequences of the test would be.

Are extreme negative events in the probability distribution (war, natural disasters, crashes in general) priced accurately by the market? In the case of S&P options, deep out of the money puts (which are essentially crash insurance) have a big premium built into their price (see here for details). Contrary to some people's folk wisdom, the derivatives market does not underestimate the probability of rare negative events. On the other hand, the utility or payoff function for ordinary fund managers probably tells them to ignore rare negative events. Insuring against such events is a drag on their performance, as they are evaluated against a benchmark that typically includes no such insurance. In the event of a catastrophe, they'll be in good company and the damage sustained by their career will probably be less than the damage to their portfolio (i.e., the investor will suffer more than the manager).


Jason said...

There was a recent (well maybe not so recent now) paper by Niall Ferguson talking about how the bond markets failed to anticipate WWI, even though it seemed apparent to almost everyone else. Sadly, I don't have a link on me, but I'll post it if I dig it up.

Also, I thought the volatility smile was a recent event? I don't think it existed pre 87.

steve said...

Ferguson might discuss it in his new book, War of the World. I think I heard him mention it in an interview.

Yes, the vol smile is recent. Nowadays traders are well aware of fat-tail risk!

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