Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees

Bryan T. Kelly, Hanno Lustig and Stijn Van Nieuwerburgh

No 17149, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks. The basket-index put spread rises fourfold from 0.8 cents per dollar insured before the financial crisis to 3.8 cents during the crisis for deep out-of-the-money options. The spread peaks at 12.5 cents per dollar, or 70% of the value of the index put. The rise in the put spread cannot be attributed to an increase in idiosyncratic risk because the correlation of stock returns increased during the crisis. The government's collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis. The model solves the problem of how to measure systemic risk in a world where the government distorts market prices.

JEL-codes: G01 G12 G2 G38 (search for similar items in EconPapers)
Date: 2011-06
New Economics Papers: this item is included in nep-rmg
Note: AP EFG
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Published as Bryan Kelly & Hanno Lustig & Stijn Van Nieuwerburgh, 2016. "Too-Systemic-to-Fail: What Option Markets Imply about Sector-Wide Government Guarantees," American Economic Review, American Economic Association, vol. 106(6), pages 1278-1319, June.

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Related works:
Journal Article: Too-Systemic-to-Fail: What Option Markets Imply about Sector-Wide Government Guarantees (2016)
Working Paper: Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees (2012)
Working Paper: Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees (2011)
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