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

59 Pages Posted: 20 Jun 2011  

Bryan T. Kelly

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Hanno N. Lustig

Stanford Graduate School of Business; 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)

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Date Written: June 2011

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.

Suggested Citation

Kelly, Bryan T. and Lustig, Hanno N. and Van Nieuwerburgh, Stijn, Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees (June 2011). NBER Working Paper No. w17149. Available at SSRN: https://ssrn.com/abstract=1866108

Bryan T. Kelly (Contact Author)

University of Chicago - Booth School of Business ( email )

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National Bureau of Economic Research (NBER) ( email )

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Hanno N. Lustig

Stanford Graduate School of Business ( email )

Stanford GSB
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National Bureau of Economic Research (NBER)

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Stijn Van Nieuwerburgh

New York University Stern School of Business, Department of Finance ( email )

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Suite 9-190
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Centre for Economic Policy Research (CEPR)

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London, EC1V 3PZ
United Kingdom

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