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

A conspicuous amount of aggregate tail risk is missing from the price of financial sector crash insurance during the 2007-2009 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 level. At the same time, correlations among bank stocks surge, suggesting the high put spread cannot be attributed to a relative increase in idiosyncratic risk. We show that this phenomenon is unique to the financial sector, that it cannot be explained by observed risk dynamics (volatilities and correlations), and that illiquidity and no-arbitrage violations are unlikely culprits. Instead, we provide evidence that a collective government guarantee for the financial sector lowers index put prices far more than those of individual banks, explaining the divergence in the basket-index spread. By embedding a bailout in the standard one-factor option pricing model, we can closely replicate observed put spread dynamics. During the crisis, the spread responds acutely to government intervention announcements

The Cross-Section and Time-Series of Stock and Bond Returns

We propose a three-factor model that jointly prices the cross-section of returns on portfolios of stocks sorted on the book-to-market dimension, the cross-section of government bonds sorted by maturity, and time series variation in expected bond returns. The main insight is that innovations to the nominal bond risk premium price the book-to-market sorted stock portfolios. We argue that these innovations capture business cycle risk and show that dividends of the highest book-to-market portfolio fall substantially more than those of the low book-to-market portfolio during NBER recessions. We propose a structural model that ties together the nominal bond risk premium, the cross-section of book-to-market sorted stock portfolios, and recessions. This model is quantitatively consistent with the observed value, equity, and nominal bond risk premia

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

A conspicuous amount of aggregate tail risk is missing from the price of financial sector crash insurance during the 2007-2009 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 level. At the same time, correlations among bank stocks surge, suggesting the high put spread cannot be attributed to a relative increase in idiosyncratic risk. We show that this phenomenon is unique to the financial sector, that it cannot be explained by observed risk dynamics (volatilities and correlations), and that illiquidity and no-arbitrage violations are unlikely culprits. Instead, we provide evidence that a collective government guarantee for the financial sector lowers index put prices far more than those of individual banks, explaining the divergence in the basket-index spread. By embedding a bailout in the standard one-factor option pricing model, we can closely replicate observed put spread dynamics. During the crisis, the spread responds acutely to government intervention announcements

Consumption Based Asset Pricing Models: Theory

The essential element in modern asset pricing theory is a positive random variable called “the stochastic discount factor” (SDF). This object allows one to price any payoff stream. Its existence is implied by the absence of arbitrage opportunities. Consumption-based asset pricing models link the SDF to the marginal utility growth of investors—and in turn to observable economic variables—and in doing so, they provide empirical content to asset pricing theory. This entry discusses this class of models