Predicting Financial Distress in a High-Stress Financial World: The Role of Option Prices as Bank Risk Metrics

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.