What Option Markets Imply About Sector-Wide Government Guarantees

Investors in option markets price-in a substantial collective government bailout guarantee in the financial sector.

During economic downturns, governments seek to mitigate the risk and repercussions of financial disasters by providing guarantees to financial institutions that are deemed integral to the stability of the financial system. In Too-Systemic-To-Fail: What Option Markets Imply about Sector-Wide Government Guarantees (NBER Working Paper No. 17149), co-authors Bryan Kelly, Hanno Lustig, and Stjin Van Nieuwerburgh analyze equity option markets to study the size and the effect of these too-systemic-to-fail government guarantees.

Because guarantees only kick in during a financial crisis, their effect should be the most visible in the prices of assets that mainly reflect "tail risk", such as put options. (A put option on a particular stock pays an investor the difference between a pre-specific strike price and the price of the stock on the date when the options expire, provided that the stock price is below the strike price. Thus, the payoff to the holder of a put option rises as the stock price falls.)

The results of this study show that investors in option markets price-in a substantial collective government bailout guarantee in the financial sector. This removes part of the sector-wide risk, by putting a floor on the equity value of the financial sector as a whole but not on the value of the individual firms, thus not reducing the individual firm risk. Therefore, the government guarantee makes put options on the financial sector index "cheap" relative to put options on its member banks.

Indeed, the basket-index put spread rose 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. An increase in the spread between the basket and the index means that financial sector index options became cheaper relative to the individual firm options. The spread peaked at 12.5 cents per dollar, or 70 percent of the value of the index put. The rise in the put spread cannot be attributed to an increase in individual firm risk because the correlation of stock returns increased during the crisis. The correlations for financials were invariably higher than for non-financials, and the volatility risk premium for financials decreased during the crisis. That was yet another indication that index put options on the financial sector were cheap during the crisis.

The authors provide evidence that the dynamics of the basket-index spread during the crisis were closely tied to government announcements directly related to the collective bailout. Their results suggest that the market was not initially reassured by the TARP program and its implementation, which consisted mostly of cash infusions from sales of preferred shares. Only when the Treasury and the Federal Reserve explicitly announced programs to purchase toxic assets such as mortgage-backed securities did the collective bailout guarantee become valuable.

--Claire Brunel