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

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  • Kelly, Bryan
  • Lustig, Hanno
  • van Nieuwerburgh, Stijn

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.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9023.

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Date of creation: Jun 2012
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Handle: RePEc:cpr:ceprdp:9023

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

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References

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  1. David Backus & Mikhail Chernov & Ian Martin, 2009. "Disasters Implied by Equity Index Options," Working Papers 09-14, New York University, Leonard N. Stern School of Business, Department of Economics.
  2. Longstaff, Francis A. & Piazzesi, Monika, 2004. "Corporate earnings and the equity premium," Journal of Financial Economics, Elsevier, vol. 74(3), pages 401-421, December.
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  7. O'Hara, Maureen & Shaw, Wayne, 1990. " Deposit Insurance and Wealth Effects: The Value of Being "Too Big to Fail."," Journal of Finance, American Finance Association, vol. 45(5), pages 1587-1600, December.
  8. Priyank Gandhi & Hanno Lustig, 2010. "Size Anomalies in U.S. Bank Stock Returns: A Fiscal Explanation," NBER Working Papers 16553, National Bureau of Economic Research, Inc.
  9. Xavier Gabaix, 2008. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," NBER Working Papers 13724, National Bureau of Economic Research, Inc.
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Cited by:
  1. Marcin Kacperczyk & Philipp Schnabl, 2011. "Implicit Guarantees and Risk Taking: Evidence from Money Market Funds," NBER Working Papers 17321, National Bureau of Economic Research, Inc.
  2. Javier Bianchi, 2012. "Efficient Bailouts?," 2012 Meeting Papers 162, Society for Economic Dynamics.
  3. Jaromir Nosal & Guillermo Ordoñez, 2013. "Uncertainty as commitment," National Bank of Poland Working Papers 141, National Bank of Poland, Economic Institute.

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