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Predicting Financial Distress in a High-Stress Financial World: The Role of Option Prices as Bank Risk Metrics

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Author Info

  • Coffinet, J.
  • Pop, A.
  • Tiesset, M.

Abstract

The current financial crisis offers a unique opportunity to investigate the leading properties of market indicators in a stressed environment and their usefulness from a banking supervision perspective. One pool of relevant information that has been little explored in the empirical literature is the market for bank’s exchange-traded option contracts. In this paper, we first extract implied volatility indicators from the prices of the most actively traded option contracts on financial firms’ equity. We then examine empirically their ability to predict financial distress by applying survival analysis techniques to a sample of large US financial firms. We find that market indicators extracted from option prices significantly explain the survival time of troubled financial firms and do a better job in predicting financial distress than other time-varying covariates typically included in bank failure models. Overall, both accounting information and option prices contain useful information of subsequent financial problems and, more importantly, the combination produces good forecasts in a high-stress financial world, full of doubts and uncertainties.

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Bibliographic Info

Paper provided by Banque de France in its series Working papers with number 311.

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Length: 37 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:bfr:banfra:311

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Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS
Web page: http://www.banque-france.fr/
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Related research

Keywords: Financial distress; Financial system oversight; Market discipline; Options; Implied volatility; Survival analysis.;

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References

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  1. John Krainer & Jose A. Lopez, 2004. "Using securities market information for bank supervisory monitoring," Working Paper Series 2004-05, Federal Reserve Bank of San Francisco.
  2. Larry D. Wall, 2010. "Prudential discipline for financial firms: micro, macro, and market structures," Working Paper 2010-09, Federal Reserve Bank of Atlanta.
  3. Swidler, Steve & Wilcox, James A., 2002. "Information about bank risk in options prices," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 1033-1057, May.
  4. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2002. "Equity and bond market signals as leading indicators of bank fragility," Working Paper Series 0150, European Central Bank.
  5. Allen N. Berger & Sally M. Davies & Mark J. Flannery, 1998. "Comparing market and supervisory assessments of bank performance: who knows what when?," Finance and Economics Discussion Series 1998-32, Board of Governors of the Federal Reserve System (U.S.).
  6. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," Working Paper 2000-24, Federal Reserve Bank of Atlanta.
  7. Cole, Rebel A. & Gunther, Jeffery W., 1995. "Separating the likelihood and timing of bank failure," Journal of Banking & Finance, Elsevier, vol. 19(6), pages 1073-1089, September.
  8. Douglas D. Evanoff & Larry D. Wall, 2001. "Measures of the riskiness of banking organizations: Subordinated debt yields, risk-based capital, and examination ratings," Working Paper 2001-25, Federal Reserve Bank of Atlanta.
  9. Flannery, Mark J, 1998. "Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(3), pages 273-305, August.
  10. Douglas Evanoff & Larry Wall, 2001. "Sub-debt Yield Spreads as Bank Risk Measures," Journal of Financial Services Research, Springer, vol. 20(2), pages 121-145, October.
  11. Jagtiani, Julapa & Lemieux, Catharine, 2001. "Market discipline prior to bank failure," Journal of Economics and Business, Elsevier, vol. 53(2-3), pages 313-324.
  12. DeYoung, Robert, et al, 2001. "The Information Content of Bank Exam Ratings and Subordinated Debt Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(4), pages 900-925, November.
  13. Boyd, John, 2000. "Comment on Comparing Market and Supervisory Assessments of Bank Performance: Who Knows What, When?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 668-70, August.
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Cited by:
  1. Matros, Philipp & Vilsmeier, Johannes, 2012. "Measuring option implied degree of distress in the US financial sector using the entropy principle," Discussion Papers 30/2012, Deutsche Bundesbank, Research Centre.
  2. Milne, Alistair, 2014. "Distance to default and the financial crisis," Journal of Financial Stability, Elsevier, vol. 12(C), pages 26-36.

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