Abstract

We examine the pricing of financial crash insurance during the 2007-2009 financial crisis in U.S. option markets, and we show that a large amount of aggregate tail risk is missing from the cost of financial sector crash insurance during the crisis. The difference in costs between 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 lowers index put prices far more than those of individual banks and explains the increase in the basket-index put spread.

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Citation

Kelly, Bryan, Hanno Lustig, and Stijn Van Nieuwerburgh. "Too-Systemic-to-Fail: What Option Markets Imply About Sector-Wide Government Guarantees." American Economic Review 106, no. 6 (June 2016): 1278-1319.

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