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: |
Web page: http://www.EconomicDynamics.org/society.htm
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Gary B. Gorton & Andrew Metrick, 2009.
"Securitized Banking and the Run on Repo,"
NBER Working Papers
15223, National Bureau of Economic Research, Inc.
- Gary Gorton & Andrew Metrick, 2010. "Securitized Banking and the Run on Repo," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
- Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
- Priyank Gandhi & Hanno Lustig, 2010. "Size Anomalies in U.S. Bank Stock Returns: A Fiscal Explanation," NBER Working Papers 16553, National Bureau of Economic Research, Inc.
- Francis Longstaff & Monika Piazzesi, 2003.
"Corporate Earnings and the Equity Premium,"
NBER Working Papers
10054, National Bureau of Economic Research, Inc.
- Backus, David & Chernov, Mikhail & Martin, Ian, 2009.
"Disasters implied by equity index options,"
CEPR Discussion Papers
7416, C.E.P.R. Discussion Papers.
- David Backus & Mikhail Chernov & Ian Martin, 2009. "Disasters Implied by Equity Index Options," Working Papers 09-14, New York University, Leonard N. Stern School of Business, Department of Economics.
- David Backus & Mikhail Chernov & Ian Martin, 2009. "Disasters implied by equity index options," NBER Working Papers 15240, National Bureau of Economic Research, Inc.
- Darrell Duffie, 2010. "Presidential Address: Asset Price Dynamics with Slow-Moving Capital," Journal of Finance, American Finance Association, vol. 65(4), pages 1237-1267, 08.
- Joost Driessen & Pascal J. Maenhout & Grigory Vilkov, 2009. "The Price of Correlation Risk: Evidence from Equity Options," Journal of Finance, American Finance Association, vol. 64(3), pages 1377-1406, 06.
- Hanno Lustig, 2011.
"Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle,"
2011 Meeting Papers
1443, Society for Economic Dynamics.
- Matthias Fleckenstein & Francis A. Longstaff & Hanno Lustig, 2010. "Why Does the Treasury Issue Tips? The Tips-Treasury Bond Puzzle," NBER Working Papers 16358, National Bureau of Economic Research, Inc.
- Gourio, François, 2008.
"Time-series predictability in the disaster model,"
Finance Research Letters,
Elsevier, vol. 5(4), pages 191-203, December.
- François Gourio, 2008. "Time-series predictability in the disaster model," Boston University - Department of Economics - Working Papers Series wp2008-016, Boston University - Department of Economics.
- Xavier Gabaix, 2008.
"Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance,"
NBER Working Papers
13724, National Bureau of Economic Research, Inc.
- Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
- Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
- Stefano Giglio, 2011. "Credit default swap spreads and systemic financial risk," Proceedings 1122, Federal Reserve Bank of Chicago.
- Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
- Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
- O'Hara, Maureen & Shaw, Wayne, 1990. " Deposit Insurance and Wealth Effects: The Value of Being "Too Big to Fail."," Journal of Finance, American Finance Association, vol. 45(5), pages 1587-1600, December.
- Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
When requesting a correction, please mention this item's handle: RePEc:red:sed011:1285. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann)
If references are entirely missing, you can add them using this form.