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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/31427
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| Title: | Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide
Government Guarantees |
| Authors: | Nieuwerburgh, Stijn Van
Lustig, Hanno N.
Kelly, Bryan T. |
| Issue Date: | 9-Jan-2012 |
| Series/Report no.: | FIN-11-052 |
| 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 fourfold 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 unique
to the financial sector, that it cannot be explained by observed risk
dynamics (volatilities and correlations), and that illiquidity and
no-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. |
| URI: | http://hdl.handle.net/2451/31427 |
| Appears in Collections: | Finance Working Papers
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