Option-Based Intermediary Leverage

We introduce an option-implied proxy for the health of financial intermediaries—the Leverage Bearing Capacity (LBC). LBC is the leverage of a fictitious intermediary that targets a fixed level of risk and rebalances its capital structure on an ongoing basis. Our measure is based on market values, available at any frequency, and naturally incorporates higher moments. We analyze the dynamics of LBC within simulation and event studies and demonstrate that LBC is tightly linked to financial sector uncertainty. Building on an intermediary asset pricing model, we validate that LBC proxies the marginal wealth of intermediaries. Empirically, LBC explains the expected returns across several asset classes and subsumes the explanatory power of existing measures of intermediaries’ health, financial uncertainty, and common risk factors.