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Measuring Option Implied Degree of Distress in the US Financial Sector Using the Entropy Principle

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  • Philipp Matros
  • Johannes Vilsmeier

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 ob- tained 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 nancial sector. We find that the PoDs are superior to CDS in identifying the high risk banks prior to the Lehman crisis.

Suggested Citation

  • Philipp Matros & Johannes Vilsmeier, 2012. "Measuring Option Implied Degree of Distress in the US Financial Sector Using the Entropy Principle," Working Papers 123, Bavarian Graduate Program in Economics (BGPE).
    • Handle: RePEc:bav:wpaper:123_matrosvilsmeier
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    File URL: http://www.bgpe.de/texte/DP/123_MatrosVilsmeier.pdf
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    References listed on IDEAS

    as
    1. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-651, October.
    2. Christian Capuano, 2008. "The Option-iPoD," IMF Working Papers 2008/194, International Monetary Fund.
    3. Jérôme Coffinet & Adrian Pop & Muriel Tiesset, 2010. "Predicting Financial Distress in a High-Stress Financial World: The Role of Option Prices as Bank Risk Metrics," Working Papers hal-00547744, HAL.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Philipp Matros & Johannes Vilsmeier, 2013. "The Multivariate Option iPoD Framework - Assessing Systemic Financial Risk," Working Papers 143, Bavarian Graduate Program in Economics (BGPE).
    2. Vilsmeier, Johannes, 2014. "Updating the option implied probability of default methodology," Discussion Papers 43/2014, Deutsche Bundesbank.
    3. Matros, Philipp & Vilsmeier, Johannes, 2014. "The multivariate option iPoD framework: assessing systemic financial risk," Discussion Papers 20/2014, Deutsche Bundesbank.

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    More about this item

    Keywords

    Entropy Principle; Risk Neutral Density; Probability of Default; Financial Stability Indicator; Credit Default Swaps;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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