Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees
Investors in option markets perceive the financial sector to be too-systemic-to-fail. They price in a substantial collective government bailout guarantee, which puts a floor on the value of the financial sector as a whole, but not on its individual members. 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 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. Sector-wide tail risk, partially absorbed by the government's collective guarantee for the financial sector, lowers the index put prices but not the individual put prices, and hence can explain the basket-index spread. A structural model quantitatively matches these facts and indicates that as much as half of the value of the financial sector during the crisis. The model solves the problem of how to measure systemic risk in a world where the government distorts market prices.
|Date of creation:||2011|
|Date of revision:|
|Contact details of provider:|| Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA|
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