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

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.