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

  • Jérôme Coffinet

    ()

    (Banque de France - Banque de France)

  • Adrian Pop

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

  • Muriel Tiesset

    ()

    (Banque de France - Banque de France)

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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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
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  1. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2006. "Equity and Bond Market Signals as Leading Indicators of Bank Fragility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 399-428, March.
  2. Rebel A. Cole & Jeffery W. Gunther, 1993. "Separating the likelihood and timing of bank failure," Finance and Economics Discussion Series 93-20, Board of Governors of the Federal Reserve System (U.S.).
  3. John Krainer & Jose A. Lopez, 2004. "Using securities market information for bank supervisory monitoring," Working Paper Series 2004-05, Federal Reserve Bank of San Francisco.
  4. Douglas D. Evanoff & Larry D. Wall, 2001. "Measures of the riskiness of banking organizations: Subordinated debt yields, risk-based capital, and examination ratings," FRB Atlanta Working Paper 2001-25, Federal Reserve Bank of Atlanta.
  5. DeYoung, Robert, et al, 2001. "The Information Content of Bank Exam Ratings and Subordinated Debt Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(4), pages 900-925, November.
  6. Larry D. Wall, 2010. "Prudential discipline for financial firms: micro, macro, and market structures," FRB Atlanta Working Paper 2010-09, Federal Reserve Bank of Atlanta.
  7. 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, vol. 32(3), pages 668-70, August.
  8. Berger, Allen N & Davies, Sally M & Flannery, Mark J, 2000. "Comparing Market and Supervisory Assessments of Bank Performance: Who Knows What When?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 641-67, August.
  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, 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, vol. 53(2-3), pages 313-324.
  11. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," FRB Atlanta Working Paper 2000-24, Federal Reserve Bank of Atlanta.
  12. Swidler, Steve & Wilcox, James A., 2002. "Information about bank risk in options prices," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 1033-1057, May.
  13. Douglas D. Evanoff & Larry D. Wall, 2001. "Sub-debt yield spreads as bank risk measures," Working Paper Series WP-01-03, Federal Reserve Bank of Chicago.
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