
Quantifying the Nightmare Scenarios - soundsop
http://freakonomics.blogs.nytimes.com/2009/03/02/quantifying-the-nightmare-scenarios/
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nkurz
From the article: "In other words, option prices suggest that there is a very
real chance of, dare I write it, another Great Depression."

I thought that option prices were mathematically priced primarily on the
volatility of the underlying stock or index, with the market makers taking no
position on the direction of the price change one way or another. This would
make the statement above equivalent to "the recent drop in the market shows
that there is a risk of a much larger drop", which seems sort of obvious.

Am I missing something deeper?

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danteembermage
If you think about options as a form of insurance, then we can infer something
about the marginal investors beliefs about various scenarios by the price
they're willing to pay to protect themselves from them.

Right now, the risk-neutral expectation is that the S&P will appreciate by 5
to 30% over the next year, but the strong concern that the market will drop
catastrophically drives up demand for insurance against a depression. So on
average the options market looks pessimistic even though in some sense the
median belief is that the market will go up.

This is not the way perceptions have to go, for example the greatest mass of
investors might have been around -5% to -30% but a smaller group, convinced
the market would quickly rebound to beyond its former glory, might produce a
net effect of slightly rosy.

So in essence using options prices we can determine that in general investors
are not thinking "yay, bargains" rather "yikes, mattress"

