Do prices in the option market have information that can be used to determine the distribution of risks? Dr. Myron Scholes shares why monitoring these signals matters.

View Transcript

I believe that the credit markets, the option markets, have a lot of information, and they don’t have great information maybe for one-year options or five-year options, but they have a lot of information about near-term risks, three-month risk, two-month risks. Do market prices in the option market have information that can be used to determine the distribution of risks? And the answer to that is definitely yes. The option market is an insurance market. It’s a strange insurance market in that the put option protects your downside, and the call option is, you know, protects the upside.

The people who are, are the very active and smart traders who realize that risk is increasing and they might be stuck at the assets they’re holding, they go with the option market because the assets they’re holding might be illiquid but they want to buy market protection. They want to protect against the beta risk and so they reveal themselves through the decision to implement the protection, or to lift the protection, or reduce the price of the protection, or to participate in the upside, you know, through acquiring out of the money calls.

The way I think about it is that the option market should have a lot of information … and it does. If you look historically back even to 1987, the out of the money puts were increasing in value before the market crash of ’87. And similarly you had the case in 2001, and you had the case again in 2007 and 2008, the option markets were, the prices of puts were increasing dramatically before the actual market went down in extreme ways. It was going down and then the price of the puts also indicated that the probability was higher that the market would continue down because people were buying protection.

So the information in the risk markets tells you how to adjust your risk of your portfolio. They’re all in the same loop. So now the question becomes why is it the case that the equity markets don’t incorporate this information, and they could. I mean they could. They could, it would be my joy in life to see that the equity markets reflect the risk dimension correctly. And I do believe the reason we don’t see it, however, and it’s my passion in life to get us to see it, is because of this constraint, because of the tracking error constraint. The indices you have, whether it’s the MSCI, ACWI indexes, or the S&P 500 or all the passive investment funds, they’re all relative performance, they’re relative values so everyone sticks to the benchmark. Everyone’s afraid to deviate from the benchmark. If you say the cost is my job to deviate from the benchmark, if the benchmark goes down 50% and I’m at the benchmark, I can be in the herd and everything is fine, I save my job. But is that the job one really should have? The job should be to maximize the terminal value of the portfolio for investors. So if that’s your job, you should be compensated that way, but the job that many managers that I talk to, the job that many allocators that I talk to have, is to outperform or stay close to the benchmark.

The economic rationale is it’s very costly to generate the trust of investors, and it’s very costly to measure their performance if you don’t have a benchmark. Trading off that cost, in lost return because you’re not using information to deviate from the benchmark, leads to an implicit cost in terms of lost return. So you have an explicit cost you reduce, and implicit cost you increase because you’re not dynamically managing the risk of your portfolio to enhance compound returns.

In using option prices to estimate the distribution of risk that the market is forecasting, the prices have to be good prices. And you need liquid markets. The prices we use to estimate the distributions themselves are the shorter end of the market. You know, the two-month, three-month options that have a large open interest, have very narrow spreads, have a great amount of trading volume so that market information prices are rich in information. And so that’s number one. Number two is since there’s a great cross-section of information in the option market, there’s not just one strike price. The whole, the distribution of prices, and one could use that information not only in the one strike price but of all the prices of options for that particular asset to be able to then figure out whether that sequence, or the whole series is a good sequence to use. You know, one of the nice things about tail risk management is in the growth sector, if one asset has a bad result, other assets are going to have bad results as well. So, the information is rich in the cross-section because you have a whole cross-section of growth securities you can use to estimate.

Janus Henderson offers active management products. We are complementary to so many of the other Janus Henderson strategies because they’re focusing on outperformance of a benchmark. And our job is, we’re beta managers, or risk managers, and they’re asset selectors, generally are trying to select assets that outperform.

A solutions business is different from a product focus. We have products, but at the same time we hope, we work with investors. Our job is to enhance the performance, or mitigate, enhance the compound return experience. I’m not saying the average; we’re in the compound return experience through dynamic risk management strategies.

Options (calls and puts) involve risks. Option trading can be speculative in nature and carries a substantial risk of loss.