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

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

By
Bryan T. Kelly, Hanno Lustig, Stijn Van Nieuwerburgh
American Economic Review . June
2016, Vol. 1106, Issue 6, Pages 1278-1319

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.