Working Paper: NBER ID: w17149
Authors: Bryan T. Kelly; Hanno Lustig; Stijn Van Nieuwerburgh
Abstract: Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks. The basket-index put spread rises fourfold from 0.8 cents per dollar insured before the financial crisis to 3.8 cents during the crisis for deep out-of-the-money options. The spread peaks at 12.5 cents per dollar, or 70% of the value of the index put. The rise in the put spread cannot be attributed to an increase in idiosyncratic risk because the correlation of stock returns increased during the crisis. The government's collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis. The model solves the problem of how to measure systemic risk in a world where the government distorts market prices.
Keywords: government guarantees; option pricing; financial crisis; systemic risk
JEL Codes: G01; G12; G2; G38
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government guarantees (H81) | cost of capital for systemically risky financial firms (G32) |
| government guarantees (H81) | put options on financial sector index pricing (G13) |
| government guarantees (H81) | basket-index put spread (G13) |
| government guarantees (H81) | flattening of the volatility skew for deep out-of-the-money put options (G13) |
| collective government bailout guarantee (H81) | truncates distribution of equity values for the financial sector (D39) |
| bailout guarantee (H81) | mitigates aggregate tail risk (G52) |
| bailout guarantee (H81) | leaves individual firm risks intact (G33) |