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Measuring option implied degree of distress in the US financial sector using the entropy principle

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  • Matros, Philipp
  • Vilsmeier, Johannes
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    Abstract

    We estimate time series of option implied Probabilities of Default (PoDs) for 19 major US financial institutions from 2002 to 2012. These PoDs are estimated as mass points of entropy based risk neutral densities and subsequently corrected for maturity dependence. The obtained time series are evaluated with regard to their consistency and predictive power and their properties are compared to Credit Default Swap Spreads (CDS). Moreover, we also derive an indicator for the systemic risk in the US financial sector. We find that the PoDs are superior to CDS in identifying the high risk banks prior to the Lehman crisis. --

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    Bibliographic Info

    Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Papers with number 30/2012.

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    Date of creation: 2012
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    Handle: RePEc:zbw:bubdps:302012

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    Keywords: Entropy Principle; Risk Neutral Density; Probability of Default; Financial Stability Indicator; Credit Default Swaps;

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    1. Christian Capuano, 2008. "The Option-Ipod. the Probability of Default Implied by Option Prices Basedon Entropy," IMF Working Papers 08/194, International Monetary Fund.
    2. Coffinet, J. & Pop, A. & Tiesset, M., 2010. "Predicting Financial Distress in a High-Stress Financial World: The Role of Option Prices as Bank Risk Metrics," Working papers, Banque de France 311, Banque de France.
    3. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 51(4), pages 621-51, October.
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