dodd-frank reduced intermediary capital in the underlying (equities) while capital committed to derivatives remained the same or was enhanced
the tool for derivative regulation is, really, the potential for a regulatory slap on the risk from the Fed if a disaster scenario stress test is failed
interestingly the test is the "mark to model" of outcomes with a (i) decline in price of the underlying and (ii) increase in volatility (the 2 big contributors the price of a derivative)
the model is the intermediaries expectation of portfolio values (a guess) and not an exhange traded, transparent value (oh my)
the penalties for failure range from a letter of reprimand to roughly one months worth of the intermediaries cash flow paid 60 months hence
for paper and other mache purposes the intermediaries are loading up on derivatives that pay off at lower prices and higher vol for a fraction of what they are selling that plus other insurance to customers
the skew is the view
the tool for derivative regulation is, really, the potential for a regulatory slap on the risk from the Fed if a disaster scenario stress test is failed
interestingly the test is the "mark to model" of outcomes with a (i) decline in price of the underlying and (ii) increase in volatility (the 2 big contributors the price of a derivative)
the model is the intermediaries expectation of portfolio values (a guess) and not an exhange traded, transparent value (oh my)
the penalties for failure range from a letter of reprimand to roughly one months worth of the intermediaries cash flow paid 60 months hence
for paper and other mache purposes the intermediaries are loading up on derivatives that pay off at lower prices and higher vol for a fraction of what they are selling that plus other insurance to customers
the skew is the view
http://www.bloomberg.com/news/articles/2015-12-09/who-s-the-bear-driving-up-the-price-of-u-s-stock-options-banks
Since so many banking institutions are facing these stress tests, the types of protection that help banks do well in these scenarios obtain extra value,” said Rocky Fishman, an equity derivatives strategist at Deutsche Bank. “The way the marketplace has compensated for that is by driving up S&P skew.”
The Federal Reserve’s Comprehensive Capital Analysis & Review, or CCAR, has become one of the most important annual events for the largest banks. It determines whether trading units, including equity derivatives, can handle a market shock and pay out capital to shareholders. In the test, banks must demonstrate that they can weather a crisis and stay above minimum capital ratios even as their amount of equity is reduced by losses and the planned dividends and buybacks.
One of the reasons S&P puts have been so expensive relative to at-the-money options this year is that the severely adverse scenario prescribed by CCAR program implies a very negative shock to the S&P,” said Fishman. “It creates value for the downside options.”
The structural shift in the price of bearish options has been debated on Wall Street for months. Another explanation has focused on the firms that supply them and the possibility that regulations such as the Dodd-Frank Act have limited market making. While banks have largely ceded their market-making role on equity exchanges to automated traders, they’re still among the biggest suppliers of stock hedges.
While stress tests are cause for hedging, there are other more imminent threats to the bull market spurring people to protect gains, according to Michael Antonelli of Robert W. Baird & Co.
“A lot of people have looked at crude, valuations and projections for earnings and come to the conclusion that it’s probably a good idea to protect to the downside,” said Michael Antonelli, an institutional equity sales trader and managing director at Robert W. Baird & Co. in Milwaukee. “Peoples’ views are definitely negatively tilted when it comes to 2016. They’re very cautious and concerned about the bull market continuing.”
Crude oil prices sit at the lowest since 2009 amid a 65 percent plunge in the resource starting in mid-2014. The resource added 1.3 percent to $38 per barrel at 9:30 a.m. in New York. Meanwhile, the S&P 500 is trading at 18 times earnings, close to the highest in five years, after the gauge tripled during the bull market. Adding to bearish sentiment are corporate profits that are forecast to contract 5.6 percent in the fourth quarter, which would mark the index’s third straight period without earnings growth.
Still, the Fed stress tests remain the cornerstone of the U.S. central bank’s efforts to prevent a repeat of the 2008 financial crisis and to gauge the ability of banks to withstand economic turmoil. To Dan Deming of KKM Financial LLC, their presence will have a lasting effect on risk tolerance.
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