Can a Stock Option Predict Financial System Chaos?
Martín Saldías Zambrana, a visiting scholar at the Federal Reserve Bank of Cleveland, takes what’s known as a “contingent claims” approach in his proposal for a forward-looking systemic risk indicator. In the simplest terms, a contingent claim gives the holder the right to something else depending on what happens in the future. An option to buy a share of AIG at a certain price level during a certain time period is a type of contingent claim, for example. Zambrana uses the option-based “distance-to-default” measure developed by Moody’s KMV, a credit analysis firm. Distance to default is a measure of the probability that a firm will default, so we use the term “probability of default” in this explanation. The measure uses estimates of the market value of a firm’s assets, the volatility of the asset value, and the bankruptcy threshold (that is, the point at which the firm will become insolvent). These estimates are typically backed out of observed accounting data and the price of the fir
