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Discussion Paper Details

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

Author(s): Bryan Kelly, Hanno Lustig and Stijn van Nieuwerburgh

Publication Date: June 2012

Keyword(s): financial crisis, government bailout, option pricing models, systemic risk and too-big-to-fail

Programme Area(s): Financial Economics

Abstract: We examine the pricing of financial crash insurance during the 2007-2009 financial crisis in U.S. option markets. A large amount of aggregate tail risk is missing from the price of financial sector crash insurance during the financial crisis. The difference in costs of 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, which lowers index put prices far more than those of individual banks, explains the divergence in the basket-index put spread.

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Bibliographic Reference

Kelly, B, Lustig, H and van Nieuwerburgh, S. 2012. 'Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9023