How much is the Bernanke put worth?

Posted by Izabella Kaminska on Jun 22 17:11. 4 comments | Share

Here’s an interesting observation from a recently released NBER paper: why are put options on the financial sector index cheaper than those on member banks?

Bryan Kelly of the University of Chicago Booth School of Business, More…

Here’s an interesting observation from a recently released NBER paper: why are put options on the financial sector index cheaper than those on member banks?

Bryan Kelly of the University of Chicago Booth School of Business, Hanno Lustig of UCLA Anderson, and Stijn Van Nieuwerburgh of NYU Stern, make the following point:

The rise in the put spread cannot be attributed to an increase in idiosyncratic risk because the correlation of stock returns increased during the crisis. Sectorwide tail risk, partially absorbed by the government’s collective guarantee for the financial sector, lowers the index put prices but not the individual put prices, and hence can explain the basket-index spread.

A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis. The model solves the problem of how to measure systemic risk in a world where the government distorts market prices.

In other words, the paper suggests the value of the incorporeal Bernanke put might just be derived from the differential.

As the authors point out, by putting a floor under the equity value of the financial sector, the government eliminated part of the sector-wide tail risk — but failed to eliminate so-called idiosyncratic tail risk. One reason why stocks became more partial to tandem moves.

Thus, to estimate the value of the Bernanke put, all one has to do is measure the difference between the cost of a basket of options and an index option. And here is that chart:

The value being derived:

The basket-index spread peaks at $139 billion on October 13, 2008, or 10.5% of the financial index’s market value that day. Using a structural model, we argue below that the collective bailout guarantee accounted for as much as half of the market value of the financial sector during the crisis.

So, some $139bn for the US banks included in the index alone. Not quite as much as we would have presumed, but definitely not an insignificant figure either.

Related links:
Crouching Vix, hidden volatility – FT Alphaville
The calm before the (volatility) storm – FT Alphaville
More thoughts on what’s behind low volatility – FT Alphaville

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