The Economic Report of the President notes that after September 11, all measures of risk spreads widened.

the uniformity of stock market movements around the world suggests that a key driver of U.S. stock prices in 2002 was a worldwide decrease in tolerance for risky assets combined with lower projected earnings growth

The report also contains (p.41) a chart that shows that the spread between low-grade and high-grade corporate bonds nearly doubled after September 11, from roughly 80 basis points to roughly 145 basis points.

A money manager suggested to me that this widening spread showed that “junk bonds” are undervalued. However, this is unlikely to be the case.

There is an arbitrage relationship between junk bonds, stocks, and options. Owning a “junk bond” in a company is like owning stock in that company, writing a call option on the stock, and investing the proceeds from the sold call option in low-risk bonds. Because of this relationship, when the prices of options rise, the spread between “junk” bonds and low-risk bonds goes up as well.

After September 11, uncertainty about the future of the U.S. economy increased. This tends to raise the price of options. Higher option prices can have surprising impacts in the economy, including raising the spread between high-risk and low-risk bonds.

For Discussion. What do you think that the uncertainty about war with Iraq is doing to option prices?