Discussion paper

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

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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Citation

Van Nieuwerburgh, S, H Lustig and B Kelly (2012), ‘DP9023 Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees‘, CEPR Discussion Paper No. 9023. CEPR Press, Paris & London. https://cepr.org/publications/dp9023