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

Abstract:     
A conspicuous amount of aggregate tail risk is missing from the price of financial sector crash insurance during the 2007-2009 crisis. The difference in costs of out-of-the-money put options for individual banks, and puts on the financial sector index, increases four fold from its pre-crisis level. At the same time, correlations among bank stocks surge, suggesting the high put spread cannot be attributed to a relative increase in idiosyncratic risk. We show that this phenomenon is uniqueto the financial sector, that it cannot be explained by observed risk dynamics (volatilities and correlations), and that illiquidity andno-arbitrage violations are unlikely culprits. Instead, we provide evidence that a collective government guarantee for the financial sector lowers index put prices far more than those of individual banks,explaining the divergence in the basket-index spread. By embedding a bailout in the standard one-factor option pricing model, we can closely replicate observed put spread dynamics. During the crisis, the spread responds acutely to government intervention announcements.

Number of Pages in PDF File: 56

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