Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees
Bryan T. Kelly
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
Hanno N. Lustig
UCLA - Anderson School of Management; National Bureau of Economic Research (NBER)
Stijn Van Nieuwerburgh
New York University Stern School of Business, Department of Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
NBER Working Paper No. w17149
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.
Number of Pages in PDF File: 59
Date posted: June 20, 2011
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