Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees
78 Pages Posted: 17 Mar 2011 Last revised: 6 Aug 2015
Date Written: July 31, 2015
We examine the pricing of financial crash insurance during the 2007-2009 financial crisis in U.S. option markets, and we show that a large amount of aggregate tail risk is missing from the cost of financial sector crash insurance during the crisis. The difference in costs between out-of-the-money put options for individual banks and puts on the financial sector index increases fourfold from its pre-crisis 2003-2007 level. We provide evidence that a collective government guarantee for the financial sector lowers index put prices far more than those of individual banks and explains the increase in the basket-index put spread.
Keywords: systemic risk, government bailout, too-big-to-fail, option pricing models, disaster models, financial crisis
JEL Classification: G12, G13, G18, G21, G28, E44, E60, H23
Suggested Citation: Suggested Citation