COVID-19 and Market Expectations: Evidence from Option-implied Densities

Michael Hanke (University of Liechtenstein), Maria Kosolapova, Alex Weissensteiner (University of Bolzano)

Starting in Q1 2020, the COVID-19 pandemic has caused major disruptions to societies and economies worldwide. Economic activity has been severely impacted by lockdowns, massive travel restrictions, and other measures taken by many countries to slow down the spreading of the virus. This global health crisis is unprecedented in the modern era of a globalized economy. In its early phase, new and sometimes contradictory information came in almost by the minute, which made it difficult to forecast the pandemic’s economic impact, both short- and long-term. One way to arrive at such forecasts is to tap the “wisdom of the crowd” by extracting forecasts implied in market prices.

A number of papers written in the first half of 2020 deal with the pandemic’s economic and financial effects. Some of them analyze reactions at the individual stock level and differences in the cross-section, while others investigate reactions at the aggregate or market level. Most of these studies combine information on stock returns and dividends with other economic and health data describing the state of the pandemic in different parts of the world.

In the present study, we use information implied in prices of equity index options from six different markets (US, Japan, UK, Germany, France, Italy) to analyze how the pandemic’s financial impact was anticipated by equity option markets. While others focus on dividend growth and GDP growth from dividend futures, we estimate implied densities from option prices. The latter provide richer information than just point estimates. This allows us to gain insights into questions such as when the markets started to react, how severe the economic impact was estimated to be for different time horizons, and how these estimates changed as the pandemic unfolded in its first wave. With the benefit of hindsight, the actions of decision makers such as politicians or managers before the global spreading of the pandemic were viewed by many observers as too late, but one open question is what estimates they should/could have had at what time. Given that financial markets quickly incorporate new information into market prices, the insights gained from this analysis provide some indication regarding these questions. Expecting decision makers to be quicker in processing information than financial markets is difficult to justify.

In fact, risk-neutral densities (RND) extracted from options on six stock indices show that financial markets did not anticipate major economic effects of the COVID-19 pandemic until late February. Market expectations reflected in these RNDs show rather similar behavior until mid-March, but diverge from this time onwards. Health statistics such as the number of cases and deaths in a country seem to have some effect: stock markets in countries with lower mortality (Japan, Germany, and the US) are viewed more optimistically than those with higher mortality (France, Italy). The exception to this is the UK, which shows a relatively optimistic outlook despite a high death toll. Italy shows the most difficult prospects for any horizon, with a clear gap to the other analyzed countries. This is in line with the findings of e.g. Gerding et al. (2020), who note that a country’s fiscal capacity is a major determinant of economic losses due to rare disasters.

Alex Weissensteiner is professor of Quantitative Finance at the University of Bolzano. The article summarizes the findings in Hanke M., Kosolapova M., Weissensteiner A. (in press), Covid-19 and market expectations: Evidence from option-implied densities, Economics Letters, 19

Image credit: European Commission, holiday during Covid-19

This analysis anticipates the content of the intervention and research that will be presented at the BRIDGE Network Conference (1 – 2 October 2020)

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