I’ve wondered about this question for a while. Let’s say that bank manager/CEOs can play a profitable moral hazard game by risking that the lower left tail of the returns distribution won’t happen. Write some far out-of-the-money naked puts, or more generally synthesize that position. If you are a sports fan, imagine betting against the Washington Wizards to win an NBA title every year. Most years you earn some above-normal profits. Every now and then you go bankrupt. From the manager’s point of view there are bonuses in the good years and in the bankruptcy year the worst that can happen is getting fired. You might even be rehired rather quickly, if shareholders like such strategies too, at the expense of bondholders or taxpayers. Think of that as a private arbitrage opportunity, albeit one with negative social value.
The question is, what happens to the price of that strategy? Does it adjust to choke off more “going short volatility” at the margin? I see at least two options:
1. The return from writing a naked put (and related synthetic positions) falls somewhat, as many banks play that strategy or would play that strategy if the prices of the relevant bets did not adjust. What is then the story for the market as a whole? Are some of the “moral hazard gains” shared with those who buy naked puts? Why should the “tax incidence” problem stop there? Where exactly in the system do those gains come to rest? For sure there are gains to the early users of this moral hazard strategy, but once market prices are adjusting where do the gains go? Can excess returns be seen in observed securities prices?
Of course that there are *many* synthetic ways of writing the naked put or shorting volatility. Do the prices of all of them adjust, over time, as the early users of the strategy scurry from one opportunity, see it closed off by price shifts, and then move on to the next?
The cynic will think that hedge funds are doing well on this one.
2. Perhaps some banks play this strategy but their trades, relative to liquid markets, are not big enough to push around the price. Or maybe arbitrage is too strong and it keeps securities prices in line with standard theory.
Imagine that the fundamental value of a security was $40, but a beautiful woman would give a trader a kiss every time he bought the security, bringing his net private return to $41. Due to arbitrage and short sales, the price of the security will remain at $40, although the private gains will persist from the purchases.
In the latter case banks can’t raise enough liquidity to budge the market price, relative to the power of the other side of the market. Along related lines, legal and institutional constraints may limit the “short volatility” strategy and also blunt the effect of those strategies on market prices.
Which case is better/worse for the world as a whole? Does it matter for financial regulation which case is true?
I thank an anonymous hedge fund manager for a conversation on this topic, Interfluidity as well.