Banks stocks vs. bonds, again: a lesson in elementary option theory
April 1st, 2009By David Goldman
Theory really does work. The trouble is that there isn’t much of it. Option theory is the one really cool contribution to finance that practitioners can apply daily. It makes sense of seeming anomalies in market performance that seem to have stumped some of the pros. My post yesterday on why hedge fund players buy bank stocks and buy credit protection could use a bit of elaboration.
The WSJ Market Beat blog called attention to the discrepancy between performance of bank stocks and bank bonds during the past month: stocks up, bonds down (spreads wider). A minor-league bank strategist is quoted to the effect that credit predicts and equity confirms, so that the poor performance of bank bonds presages another drop in bank equity. In other words, the fellow trading credit default swaps knows something that the fellow trading equities doesn’t know. Considering that at hedge funds these are almost always the same people, that suggests a theory of generalized multiple personality disorder in the marketplace, in which the two sides of the personality don’t talk to each other.
As I wrote yesterday before the WSJ item came out, this has nothing to do with differing market views. It is an elementary problem in option valuation. Stocks by definition are an option on the future cash flows of a company (Merton). In the absence of dividends, e.g., the present status of C and BAC, the stock is nothing but an option on possible future cash flows. If there is extreme uncertainty — the stocks could zero out but could also dectuple — they are worth MORE, not less. If C is trading at $1 a share, as it did at the bottom, an investor could lose $1, or gain $1.5 to $2 with a very small change in its prospects. The greater the volatillity, the greater the upside vs. the downside.
Not so in credit. The opposite applies. Greater volatility means a greater chance of zeroing out. Even at 70 cents on the dollar, a Citigroup bond has more downside than upside. Preferred shares, on the other hand, at 30 cents on the dollar had more upside than downside, and traded up. It’s all about options and the effect of volatility on valuations.
With bank spreads in the hundreds and bank stock prices in single digits, the option component of equity valuation is huge, and the default option embedded in bank bonds is close to the money. Both bank stocks and bank bonds have a very high sensitivity to volatility or vega in option-speak. The signs are opposite: at very low valuations bank stocks benefit from volatility and bank senior debt loses. And that is why bank stocks go up and bank bonds go down.
April 1st, 2009 at 7:13 am
Sounds like the Salomon Brothers of old…or today’s Citi prop desk: “In other words, the fellow trading credit default swaps knows something that the fellow trading equities doesn’t know. Considering that at hedge funds these are almost always the same people, that suggests a theory of generalized multiple personality disorder in the marketplace, in which the two sides of the personality don’t talk to each other.”
April 1st, 2009 at 9:51 am
Hi David:
RE: option theory.
Nobel Winners Lucas and Prescott [PODCAST] concur with your opinion. They were on Bloomberg yesterday and compared the contribution of option theory vs. behavioral finance at some point in the discussion:
April 1st, 2009 at 10:54 am
Chipster,
This is a sensitive subject. We used to suffer from multiple personality disorder but now we’re feeling much better. I’m not schizophrenic and neither am I.
Teresa,
Must take time and listen to the podcast. When I hired quants back in the late 90s and early 2000’s — and I hired dozens of them — I didn’t much are how well they knew Ito’s lemma, but I made sure they had a profound intuition for what option theory actually means. Merton’s books were always close to hand.
April 1st, 2009 at 6:15 pm
David:
That’s an interesting observation. I have a number of junior quant friends in Europe and while they can do all sorts of fancy math, the one thing they don’t have is intuition into how things work.
Put another way, if the market were a hamburger, they will to end up debating the merit of sesame seeds on the bun rather than focus on the patty. It’s important to know where’s the beef.
April 2nd, 2009 at 7:28 pm
David,
Lovely, thank you. Yes, the application of option pricing theory to corporate financial structure is indeed the most interesting topic in financial theory, and among the most useful. But I doubt that all the implications are quite understood yet.