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  5. Too-Systemic-to-Fail: What Option Markets Imply about Sector-Wide Government Guarantees

Too-Systemic-to-Fail: What Option Markets Imply about Sector-Wide Government Guarantees

  • Bryan Kelly
  • Hanno Lustig
  • Stijn Van Nieuwerburgh
American Economic Review
vol. 106, no. 6, June 2016
(pp. 1278-1319)
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Abstract

We examine the pricing of financial crash insurance during the 2007-2009 financial crisis in US option markets, and we show that a large amount of aggregate tail risk is missing from the cost of financial sector crash insurance during the crisis. The difference in costs between out-of-the-money put options for individual banks and puts on the financial sector index increases four-fold from its precrisis 2003-2007 level. We provide evidence that a collective government guarantee for the financial sector lowers index put prices far more than those of individual banks and explains the increase in the basket-index put spread.

Citation

Kelly, Bryan, Hanno Lustig, and Stijn Van Nieuwerburgh. 2016. "Too-Systemic-to-Fail: What Option Markets Imply about Sector-Wide Government Guarantees." American Economic Review, 106 (6): 1278-1319. DOI: 10.1257/aer.20120389

Additional Materials

JEL Classification

  • E44 Financial Markets and the Macroeconomy
  • G01 Financial Crises
  • G13 Contingent Pricing; Futures Pricing; option pricing
  • G21 Banks; Depository Institutions; Micro Finance Institutions; Mortgages
  • G28 Financial Institutions and Services: Government Policy and Regulation
  • H81 Governmental Loans; Loan Guarantees; Credits; Grants; Bailouts