Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees

78 Pages Posted: 17 Mar 2011 Last revised: 6 Aug 2015

See all articles by Bryan T. Kelly

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); ABFER

Multiple version iconThere are 5 versions of this paper

Date Written: July 31, 2015

Abstract

We examine the pricing of financial crash insurance during the 2007-2009 financial crisis in U.S. 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 fourfold from its pre-crisis 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.

Keywords: systemic risk, government bailout, too-big-to-fail, option pricing models, disaster models, financial crisis

JEL Classification: G12, G13, G18, G21, G28, E44, E60, H23

Suggested Citation

Kelly, Bryan T. and Lustig, Hanno N. and Van Nieuwerburgh, Stijn, Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees (July 31, 2015). AFA 2012 Chicago Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1787247 or http://dx.doi.org/10.2139/ssrn.1787247

Bryan T. Kelly

Yale SOM ( email )

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Hanno N. Lustig

Stanford Graduate School of Business ( email )

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Columbia University Graduate School of Business ( email )

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