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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

  • Jérôme Coffinet

    ()
    (Banque de France - Banque de France)

  • Adrian Pop

    (LEMNA - Laboratoire d'économie et de management de Nantes Atlantique - Université de Nantes : EA4272)

  • Muriel Tiesset

    ()
    (Banque de France - Banque de France)

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 HAL in its series Working Papers with number hal-00547744.

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Date of creation: 01 Oct 2010
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Handle: RePEc:hal:wpaper:hal-00547744

Note: View the original document on HAL open archive server: http://hal.archives-ouvertes.fr/hal-00547744/en/
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Related research

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

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  1. Larry D. Wall, 2010. "Prudential discipline for financial firms: micro, macro, and market structures," Working Paper, Federal Reserve Bank of Atlanta 2010-09, Federal Reserve Bank of Atlanta.
  2. Cole, Rebel A. & Gunther, Jeffery W., 1995. "Separating the likelihood and timing of bank failure," Journal of Banking & Finance, Elsevier, Elsevier, vol. 19(6), pages 1073-1089, September.
  3. Douglas D. Evanoff & Larry D. Wall, 2001. "Sub-debt yield spreads as bank risk measures," Working Paper, Federal Reserve Bank of Atlanta 2001-11, Federal Reserve Bank of Atlanta.
  4. John Krainer & Jose A. Lopez, 2004. "Using securities market information for bank supervisory monitoring," Working Paper Series, Federal Reserve Bank of San Francisco 2004-05, Federal Reserve Bank of San Francisco.
  5. Reint Gropp & Jukka Vesala & Giuseppe Vulpes, 2002. "Equity and bond market signals as leading indicators of bank fragility," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, Federal Reserve Bank of Boston.
  6. Evanoff, Douglas D. & Wall, Larry D., 2002. "Measures of the riskiness of banking organizations: Subordinated debt yields, risk-based capital, and examination ratings," Journal of Banking & Finance, Elsevier, Elsevier, vol. 26(5), pages 989-1009, May.
  7. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," Working Paper, Federal Reserve Bank of Atlanta 2000-24, Federal Reserve Bank of Atlanta.
  8. Allen N. Berger & Sally M. Davies & Mark J. Flannery, 2000. "Comparing market and supervisory assessments of bank performance: who knows what when?," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, pages 641-670.
  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, Blackwell Publishing, vol. 30(3), pages 273-305, August.
  10. Jagtiani, Julapa & Lemieux, Catharine, 2001. "Market discipline prior to bank failure," Journal of Economics and Business, Elsevier, Elsevier, vol. 53(2-3), pages 313-324.
  11. DeYoung, Robert, et al, 2001. "The Information Content of Bank Exam Ratings and Subordinated Debt Prices," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 33(4), pages 900-925, November.
  12. Swidler, Steve & Wilcox, James A., 2002. "Information about bank risk in options prices," Journal of Banking & Finance, Elsevier, Elsevier, vol. 26(5), pages 1033-1057, May.
  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, 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, Elsevier, vol. 12(C), pages 26-36.

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