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Since asset volatility is directly related to default risk, it follows that IV is an important
dimension of a bank’s default risk.
We examine estimates of a bank’s IV that are calculated from exchange-traded
option prices. IV has the advantage that it brings to bear whatever information from
the past and present the market deems to be relevant to form views about the future
volatility of a bank’s share price. 3 Thus, IV is forward looking; in that regard, IV
may be superior to historically based volatility estimates.
AsMayhew (1995) points out, changes in IV are frequently thought of as the market’s
response to news that affects the future volatility of the underlying share price.
He documents that studies based on 1970s data tend to find that IV’s are superior to
HV’s in forecasting share price volatility. Research since that period has tended to
confirm that conclusion, but the evidence is not universal.
A number of studies show that useful information about market expectations can
be extracted from the prices of options. For example, Patell and Wolfson (1979)
suggest that options prices reflect investors’ opinions concerning the information
in public announcements. Patell and Wolfson (1981) examine option prices around
earnings announcements and find that IV’s fall subsequent to the news release, presumably
due to the resolution of the uncertainty about what the announcements
would say. Cornell (1978) documents that IV’s respond to announcements about
the macroeconomy. Buttimer and Swidler (1998) examine the effect of the Mexican
peso devaluation during the 1990s on the IV of foreign share prices, while Chu and
Swidler (in press) illustrate how the expected distribution of future exchange rates
can be extracted from option prices.
In examining option prices, it is important to note that the derivatives market may
offer relative transactional efficiencies over both equity and bond markets. Because
options represent highly leveraged equity positions that lower the cost of speculation,
trading in options increases market liquidity, which in turn increases the informational
efficiency of the option market. Consider, for example, an unanticipated negative
earnings announcement for a bank. Investors wishing to trade on the news
may decide to write call options or buy put options on the bank shares. However, Figlewski
and Webb (1993) point out that after an investor buys a put from a market
maker, the market professional will likely hedge by shorting the share and buying
the call option. Thus, the market maker transforms the original put trade into a short
sale at a lower cost than that of the retail investor. Ultimately this increase in transactional
efficiency should produce a gain in informational efficiency as well and provides
further motivation for investigating the informational content of bank option
prices.
The Berkeley Options Data Base (BODB) and the CRSP dividend database contain
data that permits estimating the IV’s of bank share prices. The BODB contains
the second in time at which each option trade takes place on the CBOE, as well as
pertinent information about the strike price, time until expiration, and so on.
Stewart Mayhew graciously provided us with his estimates of IV’s for each bank
in our sample. 4 To compute IV’s, Mayhew follows the procedure used by the CBOE
to calculate the VIX, a measure of the IV of the S&P 100 index of share prices. 5 He
chooses the in-the-money put and out-of-the-money call with a strike price nearest to
the underlying share price. Mayhew next averages their IV’s to produce the IV for
options with the strike price just above the bank share price. He repeats this procedure
for the out-of-the-money put and in-the-money call with strike prices closest to
the share price and averages their IV’s. Mayhew then interpolates between the two
averages to calculate an estimate of the IV for a hypothetical at-the-money option.
The result is a hypothetical, at-the-money, IV for the two option maturities greater
than one week but closest to 22 business days (roughly one calendar month). 6 A
linear interpolation/extrapolation of the two at-the-money IV’s produces an estimate
of an at-the-money option that matures in 22 days.
Mayhew uses a 100 step binomial tree to compute the IV for each individual stock
option. This process accounts for discrete dividend payments and the possibility of
early exercise. The T-bill yield serves as a proxy for the risk-free rate. Option prices
are bid/ask averages that are matched with synchronous (in time) share prices reported
in the BODB (Cornell, 1978).
We use estimates of IV’s for each business day during the period January 2, 1986
through July 31, 1997. 7 This period contains a large number of banking events and
is rich in information about risk in the banking industry generally as well as at several
individual banks. During the period around 1990 bank failures were numerous,
and a number of large and smaller banks encountered difficulties. Important events
that occur during the 1986–1997 period include: the oil and agricultural market difficulties
of the latter 1980s, the stock market drop of October 1987, the commercial
real estate loan difficulties around 1990, the introduction of the Basel capital standards
around 1990, the 1990–1991 oil price shocks, the recession of 1990–1991,
and the long and eventually vigorous economic recovery of banking and the macroeconomy
during the middle and latter 1990s.
European-style S&P 500 index options began trading in 1986. Trading of these
options spurred a dramatic increase in option market liquidity and in the number
of companies whose options are traded. Moreover, the CBOE’s calculation of the
VIX, a measure of the volatility of the S&P 100 index of share prices, also began
in 1986. The end of our sample period reflects the last full month for which the
BODB contains data for a large number of the banks in our sample. The CBOE
has not provided options data to the BODB for the period since August 1997.
We find 33 banks that both have options that are traded on the CBOE and have
SIC codes of 6712 or 6021 through 6029. Options for three banks trade for virtually
the entire 1986–1997 period: Bank of America (options ticker symbol: BAC),
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