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

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  • Bryan T. Kelly
  • Hanno Lustig
  • Stijn Van Nieuwerburgh

Abstract

Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks. The basket-index put spread rises fourfold from 0.8 cents per dollar insured before the financial crisis to 3.8 cents during the crisis for deep out-of-the-money options. The spread peaks at 12.5 cents per dollar, or 70% of the value of the index put. The rise in the put spread cannot be attributed to an increase in idiosyncratic risk because the correlation of stock returns increased during the crisis. The government’s collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis. The model solves the problem of how to measure systemic risk in a world where the government distorts market prices.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17149.

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Date of creation: Jun 2011
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Handle: RePEc:nbr:nberwo:17149

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Cited by:
  1. Javier Bianchi, 2012. "Efficient Bailouts?," 2012 Meeting Papers, Society for Economic Dynamics 162, Society for Economic Dynamics.
  2. Martin Saldías Zambrana, 2010. "Systemic risk analysis using forward-looking distance-to-default series," Working Paper 1005, Federal Reserve Bank of Cleveland.
  3. Juan Jung, 2012. "Externalities and Absorptive Capacity in a context of Spatial Dependence: The case of European Regions," Documentos de Trabajo (working papers) 2212, Department of Economics - dECON.
  4. Jaromir Nosal & Guillermo Ordoñez, 2013. "Uncertainty as Commitment," NBER Working Papers 18766, National Bureau of Economic Research, Inc.
  5. 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.
  6. Martín Saldías, 2012. "Systemic risk analysis and option-based theory and information," Economic Bulletin and Financial Stability Report Articles, Banco de Portugal, Economics and Research Department.

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