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

58 Pages Posted: 28 Sep 2012

See all articles by Bryan T. Kelly

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); ABFER; New York University (NYU)

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Date Written: June 2012

Abstract

We examine the pricing of financial crash insurance during the 2007-2009 financial crisis in U.S. option markets. A large amount of aggregate tail risk is missing from the price of financial sector crash insurance during the financial crisis. The difference in costs of 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, which lowers index put prices far more than those of individual banks, explains the divergence in the basket-index put spread.

Keywords: financial crisis, government bailout, option pricing models, systemic risk, too-big-to-fail

JEL Classification: E44, E60, G12, G13, G18, G21, G28, H23

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 2012). CEPR Discussion Paper No. DP9023, Available at SSRN: https://ssrn.com/abstract=2153455

Bryan T. Kelly

Yale SOM ( email )

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Hanno N. Lustig

Stanford Graduate School of Business ( email )

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Stijn Van Nieuwerburgh

Columbia University Graduate School of Business ( email )

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