Coronavirus (COVID-19): market fear as implied by options prices

Introduction

Stock markets around the world have tumbled since late February, when international investors began to worry about the spread of the coronavirus outside of China and its impact on the global economy. Although equity markets have partially recovered since then, the Euro Stoxx 50 lost 12.3% in the week ending on 28 February, its largest weekly percentage loss since the global financial crisis in 2008. The S&P 500 declined by more than 11% in an equally catastrophic week. Overall, equity markets in the euro area and the United States lost around 35% of their value between their peak on 19 February and their trough on 23 March.

Sources: Authors’ calculations and Refinitiv. Notes: Model-based estimates of the standard deviation of daily equity returns for four indices: the Euro Stoxx 50, the S&P 500, the FTSE 100 and the Nikkei 225. Daily data. The latest observations are for 13 April 2020.

The decline in equity prices has led to a large spike in the variance of their returns. The standard deviation of daily equity returns of major indices in the euro area, the United States, the United Kingdom and Japan is at levels comparable to the peaks associated with the October 1987 stock market crash and the default of Lehman Brothers in September 2008 (see Chart A). Recent turbulence has clearly been global in nature, as shown by the substantial jump in the standard deviation across indices. This is also reflected in a sharp rise, to values close to unity, in the bilateral correlations of equity returns for the four main equity indices, which highlights the presence of a common factor among these returns. The resulting lack of diversification opportunities also amplifies the potential losses faced by international investors.

The increased risk aversion that came on top of the heightened risks may have amplified the sell-off in equity markets and across a large range of assets more generally. Following the initial large sell-off in financial markets, an important question for policymakers when assessing the response to the crisis concerns the persistence of the impact of the restrictions related to the coronavirus on financial risk, financial conditions and, ultimately, on real economic activity. One of the main ways in which this shock has spread is via financial market linkages and, most notably, via the synchronous plunge in global stock markets. The sell-off may have been driven by an increase in the perceived amount of risk present in the markets, an increase in the reluctance of investors to take risks, or a combination of both. Knowing the main source of the decline in equity prices (and financial assets in general) may help policymakers understand its persistence and evaluate the policy response. The aim of this box is to assess the changes in the quantity and price of (tail) risks using an estimate of tail risk aversion based on the price of equity options.

Risk-neutral densities

The risk-neutral density of an equity price is the market’s estimate of the probability distribution for the future level of that equity price, adjusted for the presence of investors’ risk aversion. The risk-neutral density therefore reflects both the risk attitudes and price expectations of investors. Risk-neutral densities can be thought of as physical densities whose shape has been modified in order to give more prominence to those states of the world that are associated with particularly adverse outcomes and that, as such, result in lower marginal utility for investors.[1] We derive the risk-neutral density of future returns from the daily prices of call and put options traded on the Euro Stoxx 50.[2] On any given day, these options are available for more than one maturity, making it possible to estimate the risk-neutral density for the available range of maturities.

Fears of a market crash emerged in the early stages of the virus outbreak in Europe, but after the announcement of significant policy stimulus the expected upside potential for equity prices increased, even though market risks remained elevated. Chart B shows the Euro Stoxx 50 risk-neutral density for equity returns, backed out from options and spanning a horizon of up to one year, on three dates: (i) 21 February, just before the virus outbreak reached Europe in full force; (ii) a week later (28 February); and (iii) 20 March, after significant policy stimulus had been announced in the euro area and the United States. One can already observe a marked increase in the variance — as well as a fattening of the left tail — of the distribution in the week ending on 28 February, thus signalling increased fears of a market crash.[3] By 20 March, after significant monetary and fiscal policy measures had been announced and equity markets had already fallen sharply, the lower tail of the risk-neutral density remained broadly unchanged, but the distribution became more skewed to the upside, suggesting an increase in the expected recovery of equity returns.[4]

Sources: Authors’ calculations and Refinitiv. Note: Risk-neutral densities of future returns backed out from the daily prices of call and put options traded on the Euro Stoxx 50.

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Source: Miguel Ampudia, Ursel Baumann and Fabio Fornari | ECB Economic Bulletin