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Option-implied objective measures of market risk

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  • Leiss, Matthias
  • Nax, Heinrich H.

Abstract

Foster and Hart (2009) introduce an objective measure of the riskiness of an asset that implies a bound on how much of one’s wealth is ‘safe’ to invest in the asset while (a.s.) guaranteeing no-bankruptcy. In this study, we translate the Foster–Hart measure from static and abstract gambles to dynamic and applied finance using nonparametric estimation of risk-neutral densities from S&P 500 call and put option prices covering 2003–2013. The dynamics of the resulting ‘option-implied Foster–Hart bound’ are assessed in light of other well-known option-implied risk measures including value at risk, expected shortfall and risk-neutral volatility, as well as high moments of the densities and several industry measures. Rigorous variable selection reveals that the new measure is a significant predictor of (large) ahead-return downturns. Furthermore, it grasps more characteristics of the risk-neutral probability distributions in terms of moments than other measures and exhibits predictive consistency. The robustness of the risk-neutral density estimation is analyzed via Monte Carlo methods.

Suggested Citation

  • Leiss, Matthias & Nax, Heinrich H., 2018. "Option-implied objective measures of market risk," Journal of Banking & Finance, Elsevier, vol. 88(C), pages 241-249.
    • Handle: RePEc:eee:jbfina:v:88:y:2018:i:c:p:241-249
    DOI: 10.1016/j.jbankfin.2017.11.017
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    3. Kurosaki, Tetsuo & Kim, Young Shin, 2022. "Cryptocurrency portfolio optimization with multivariate normal tempered stable processes and Foster-Hart risk," Finance Research Letters, Elsevier, vol. 45(C).
    4. J. Arismendi-Zambrano & R. Azevedo, 2020. "Implicit Entropic Market Risk-Premium from Interest Rate Derivatives," Economics Department Working Paper Series n303-20.pdf, Department of Economics, National University of Ireland - Maynooth.
    5. Slim, Skander & Dahmene, Meriam & Boughrara, Adel, 2020. "How informative are variance risk premium and implied volatility for Value-at-Risk prediction? International evidence," The Quarterly Review of Economics and Finance, Elsevier, vol. 76(C), pages 22-37.
    6. Tetsuo Kurosaki & Young Shin Kim, 2020. "Cryptocurrency portfolio optimization with multivariate normal tempered stable processes and Foster-Hart risk," Papers 2010.08900, arXiv.org.
    7. Chia-Chi Lu & Carl Hsin-han Shen & Pai-Ta Shih & Wei‐Che Tsai, 2023. "Option implied riskiness and risk-taking incentives of executive compensation," Review of Quantitative Finance and Accounting, Springer, vol. 60(3), pages 1143-1160, April.
    8. Yuval Heller & Amnon Schreiber, 2020. "Short-Term Investments and Indices of Risk," Papers 2005.06576, arXiv.org.

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    More about this item

    Keywords

    Risk measure; Risk dynamics; Risk-neutral densities; Value at risk; Expected shortfall;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G01 - Financial Economics - - General - - - Financial Crises
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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