Too-Systemic-To-Fail: What Option Markets Teach Us About Government Guarantees For The Financial Sector

Wednesday, October 24, 2012
12:00 PM - 1:30 PM
CISAC Conference Room
  • Hanno Lustig

In this second seminar of the Europe Center's "European and Global Economic Crisis Series", Professor Hanno Lustig will discuss how a conspicuous amount of risk is missing from the price of financial sector crash insurance during the 2007-2009 crisis and that the difference in costs of put options for individual banks, and puts on the financial sector index, increases fourfold from its pre-crisis level. He provides evidence that a collective government guarantee for the financial sector lowers index put prices far more than those of individual banks, explaining the divergence. By embedding a bailout in the standard option pricing model, observed put spread dynamics is closely replicated. During the crisis, the spread responds acutely to government intervention announcements.