IDEAS home Printed from https://ideas.repec.org/a/eee/jbfina/v146y2023ics0378426622002047.html
   My bibliography  Save this article

Detecting political event risk in the option market

Author

Listed:
  • Kostakis, Alexandros
  • Mu, Liangyi
  • Otsubo, Yoichi

Abstract

This study shows that the option market can ex ante detect and quantify the effects of political event risk. Focussing on the 2016 UK referendum on EU membership, we find that the Risk-Neutral Distribution extracted from GBPUSD futures options whose expiry spans the referendum date becomes bimodal and the Implied Volatility curve exhibits an unusual W-shape. To the contrary, the corresponding effects for FTSE100 are found to be very limited. The large swings in expectations regarding the event outcome during the referendum night allow us to observe the counterfactual and validate the ex ante information revealed in the option market.

Suggested Citation

  • Kostakis, Alexandros & Mu, Liangyi & Otsubo, Yoichi, 2023. "Detecting political event risk in the option market," Journal of Banking & Finance, Elsevier, vol. 146(C).
    • Handle: RePEc:eee:jbfina:v:146:y:2023:i:c:s0378426622002047
    DOI: 10.1016/j.jbankfin.2022.106624
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0378426622002047
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jbankfin.2022.106624?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Coulomb, Renaud & Sangnier, Marc, 2014. "The impact of political majorities on firm value: Do electoral promises or friendship connections matter?," Journal of Public Economics, Elsevier, vol. 115(C), pages 158-170.
    2. Jun Liu & Francis A. Longstaff & Jun Pan, 2003. "Dynamic Asset Allocation with Event Risk," Journal of Finance, American Finance Association, vol. 58(1), pages 231-259, February.
    3. Slemrod, Joel & Greimel, Timothy, 1999. "Did Steve Forbes scare the US municipal bond market?," Journal of Public Economics, Elsevier, vol. 74(1), pages 81-96, October.
    4. Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," The Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
    5. repec:bla:jfinan:v:59:y:2004:i:1:p:407-446 is not listed on IDEAS
    6. Renaud Coulomb & Marc Sangnier, 2014. "The impact of political majorities on firm value: Do electoral promises or friendship connections matter?," Post-Print hal-01474420, HAL.
    7. Knight*, Brian, 2007. "Are policy platforms capitalized into equity prices? Evidence from the Bush/Gore 2000 Presidential Election," Journal of Public Economics, Elsevier, vol. 91(1-2), pages 389-409, February.
    8. Bryan Kelly & Ľuboš Pástor & Pietro Veronesi, 2016. "The Price of Political Uncertainty: Theory and Evidence from the Option Market," Journal of Finance, American Finance Association, vol. 71(5), pages 2417-2480, October.
    9. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
    10. P. M. Hartigan, 1985. "Computation of the Dip Statistic to Test for Unimodality," Journal of the Royal Statistical Society Series C, Royal Statistical Society, vol. 34(3), pages 320-325, November.
    11. Erik Snowberg & Justin Wolfers & Eric Zitzewitz, 2007. "Partisan Impacts on the Economy: Evidence from Prediction Markets and Close Elections," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 122(2), pages 807-829.
    12. Coutant, Sophie & Jondeau, Eric & Rockinger, Michael, 2001. "Reading PIBOR futures options smiles: The 1997 snap election," Journal of Banking & Finance, Elsevier, vol. 25(11), pages 1957-1987, November.
    13. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
    14. Bernhard,William & Leblang,David, 2006. "Democratic Processes and Financial Markets," Cambridge Books, Cambridge University Press, number 9780521678384, November.
    15. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    16. Renaud Coulomb & Marc Sangnier, 2014. "The Impact of Political Majorities on Firm Value: Do Electoral Promises or Friendship Connections Matter?," PSE Working Papers halshs-00990241, HAL.
    17. Hanke, Michael & Poulsen, Rolf & Weissensteiner, Alex, 2018. "Event-Related Exchange-Rate Forecasts Combining Information from Betting Quotes and Option Prices," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 53(6), pages 2663-2683, December.
    18. Beber, Alessandro & Breedon, Francis & Buraschi, Andrea, 2010. "Differences in beliefs and currency risk premiums," Journal of Financial Economics, Elsevier, vol. 98(3), pages 415-438, December.
    19. Borochin, Paul & Golec, Joseph, 2016. "Using options to measure the full value-effect of an event: Application to Obamacare," Journal of Financial Economics, Elsevier, vol. 120(1), pages 169-193.
    20. Coulomb, Renaud & Sangnier, Marc, 2014. "The impact of political majorities on firm value: Do electoral promises or friendship connections matter?," Journal of Public Economics, Elsevier, vol. 115(C), pages 158-170.
    21. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-651, October.
    22. Bernhard,William & Leblang,David, 2006. "Democratic Processes and Financial Markets," Cambridge Books, Cambridge University Press, number 9780521861229, November.
    23. Iain J. Clark & Saeed Amen, 2017. "Implied Distributions from GBPUSD Risk-Reversals and Implication for Brexit Scenarios," Risks, MDPI, vol. 5(3), pages 1-17, July.
    24. Michael P. Leahy & Charles P. Thomas, 1996. "The sovereignty option: the Quebec referendum and market views on the Canadian dollar," International Finance Discussion Papers 555, Board of Governors of the Federal Reserve System (U.S.).
    25. Xing, Yuhang & Zhang, Xiaoyan & Zhao, Rui, 2010. "What Does the Individual Option Volatility Smirk Tell Us About Future Equity Returns?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(3), pages 641-662, June.
    26. Justin Wolfers & Eric Zitzewitz, 2018. "The "Standard Error" of Event Studies: Lessons from the 2016 Election," AEA Papers and Proceedings, American Economic Association, vol. 108, pages 584-589, May.
    27. Philippe Jorion, 1988. "On Jump Processes in the Foreign Exchange and Stock Markets," The Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 427-445.
    28. Bliss, Robert R. & Panigirtzoglou, Nikolaos, 2002. "Testing the stability of implied probability density functions," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 381-422, March.
    29. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 231-237, December.
    30. Jackwerth, Jens Carsten & Menner, Marco, 2020. "Does the Ross recovery theorem work empirically?," Journal of Financial Economics, Elsevier, vol. 137(3), pages 723-739.
    31. Birru, Justin & Figlewski, Stephen, 2012. "Anatomy of a meltdown: The risk neutral density for the S&P 500 in the fall of 2008," Journal of Financial Markets, Elsevier, vol. 15(2), pages 151-180.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Li, Yifan & Nolte, Ingmar & Pham, Manh Cuong, 2024. "Parametric risk-neutral density estimation via finite lognormal-Weibull mixtures," Journal of Econometrics, Elsevier, vol. 241(2).
    2. Vu, Phuong Thi Thu & Huynh, Nhan & Phan, Hoa & Hoang, Hanh, 2023. "Financial earthquakes and aftershocks: From Brexit to Russia-Ukraine conflict and the stability of European banks," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 88(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Christoffersen, Peter & Jacobs, Kris & Chang, Bo Young, 2013. "Forecasting with Option-Implied Information," Handbook of Economic Forecasting, in: G. Elliott & C. Granger & A. Timmermann (ed.), Handbook of Economic Forecasting, edition 1, volume 2, chapter 0, pages 581-656, Elsevier.
    2. Draca, Mirko & Garred, Jason & Stickland, Leanne & Warrinnier, Nele, 2018. "On Target? The Incidence of Sanctions Across Listed Firms in Iran," CAGE Online Working Paper Series 372, Competitive Advantage in the Global Economy (CAGE).
    3. Carvalho, Augusto & Guimaraes, Bernardo, 2018. "State-controlled companies and political risk: Evidence from the 2014 Brazilian election," Journal of Public Economics, Elsevier, vol. 159(C), pages 66-78.
    4. Marian Micu, 2005. "Extracting expectations from currency option prices: a comparison of methods," Computing in Economics and Finance 2005 226, Society for Computational Economics.
    5. Luechinger, Simon & Moser, Christoph, 2014. "The value of the revolving door: Political appointees and the stock market," Journal of Public Economics, Elsevier, vol. 119(C), pages 93-107.
    6. Lehrer, Nimrod David, 2018. "The value of political connections in a multiparty parliamentary democracy: Evidence from the 2015 elections in Israel," European Journal of Political Economy, Elsevier, vol. 53(C), pages 13-58.
    7. Thomas Bourveau & Renaud Coulomb & Marc Sangnier, 2021. "Political Connections and White-Collar Crime: Evidence from Insider Trading in France," Journal of the European Economic Association, European Economic Association, vol. 19(5), pages 2543-2576.
    8. repec:lic:licosd:41319 is not listed on IDEAS
    9. Alhashel, Bader S., 2020. "Hail to the chief: The effect of political alignment with the presidency on corporate investment," Research in International Business and Finance, Elsevier, vol. 54(C).
    10. Labonne, Julien, 2016. "Local political business cycles: Evidence from Philippine municipalities," Journal of Development Economics, Elsevier, vol. 121(C), pages 56-62.
    11. Audinga Baltrunaite, 2020. "Political Contributions and Public Procurement: Evidence from Lithuania," Journal of the European Economic Association, European Economic Association, vol. 18(2), pages 541-582.
    12. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    13. Coulomb, Renaud & Sangnier, Marc, 2014. "The impact of political majorities on firm value: Do electoral promises or friendship connections matter?," Journal of Public Economics, Elsevier, vol. 115(C), pages 158-170.
    14. Fenske, James & Wang, Shizhuo, 2023. "Tradition and mortality: Evidence from twin infanticide in Africa," Journal of Development Economics, Elsevier, vol. 163(C).
    15. Martinez-Carrasco, José & ConceiçaÞo, Otavio & Dezolt, Ana Lúcia, 2023. "More Information, Lower Price? Access Market-based Reference Prices and Gains in Public Procurement Efficiency," IDB Publications (Working Papers) 12754, Inter-American Development Bank.
    16. Jondeau, Eric & Rockinger, Michael, 2000. "Reading the smile: the message conveyed by methods which infer risk neutral densities," Journal of International Money and Finance, Elsevier, vol. 19(6), pages 885-915, December.
    17. Brice Fabre & Marc Sangnier, 2017. "What Motivates French Pork: Political Career Concerns or Private Connections?," Working Papers halshs-01480532, HAL.
    18. Guilhem Cassan & Marc Sangnier, 2022. "The impact of 2020 French municipal elections on the spread of COVID-19," Journal of Population Economics, Springer;European Society for Population Economics, vol. 35(3), pages 963-988, July.
    19. Brice Fabre & Marc Sangnier, 2022. "Where do politicians send pork? Evidence from central government transfers to French municipalities," DeFiPP Working Papers 2202, University of Namur, Development Finance and Public Policies.
    20. Stan Olijslagers & Annelie Petersen & Nander de Vette & Sweder (S.J.G.) van Wijnbergen, 2018. "What Option Prices tell us about the ECB's Unconventional Monetary Policies," Tinbergen Institute Discussion Papers 18-096/VI, Tinbergen Institute.
    21. Stéphane Benveniste & Renaud Coulomb & Marc Sangnier, 2022. "The (Market) Value of State Honors," AMSE Working Papers 2201, Aix-Marseille School of Economics, France.

    More about this item

    Keywords

    Political event risk; Option-implied information; Risk-neutral distribution; Implied volatility curve; Brexit referendum;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jbfina:v:146:y:2023:i:c:s0378426622002047. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jbf .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.