DP9023 Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees

Author(s): Bryan Kelly, Hanno Lustig, Stijn van Nieuwerburgh
Publication Date: June 2012
Keyword(s): financial crisis, government bailout, option pricing models, systemic risk, too-big-to-fail
JEL(s): E44, E60, G12, G13, G18, G21, G28, H23
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9023

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.