Professor Bryan T. Kelly of Booth School of Business and co-authors (Prof. Hanno Lustig of UCLA and Stijn Van Nieuwerburg of New York University) undertake a field research to understand how government intervention and economic outcomes offer new insights into the effect of bailouts on the value of the banking sector.
The analysis reveals how the anticipation of a bailout impacts the well know implied volatility skew for financial sector index puts, and for a basket of individual bank puts. Since the guarantee only kicks-in when things get especially bad, the deepest out-of-the-money puts (those furthest to the left) are most severely impacted. And because it is the system, and not the individual banks, that are being insured, it is the index skew and not the basket skew that is most affected. As a result, the bailout guarantee, or the “Bernanke put” as it is more affectionately known, bends the index skew downward.
What is the upshot? Besides explaining the puzzling behavior of banking sector put options during the crisis, we demonstrate how information in the divergence between index options and the basket of options can be used to identify how guarantees affect banks’ cost of capital and, ultimately, their total market value.
Using a model of financial disasters matched to the behavior of crashes over history, they are able to attribute as much as half of the market value of the US financial sector during the crisis to the bailout guarantee. According to our estimates, the average government support of banking sector equity amounted to $0.65 billion before the crisis (2003-July 2007), and rose to $42.44 billion during the crisis (August 2007-June 2009), peaking at well over $150 billion along the way. At best we can only speculate about what kinds of resources the government consumes to implement this guarantee that props up bank stocks. But we can be certain that those resources ultimately come from taxpayer pockets.
This model also solves the problem of how to measure systemic risk in a world where the government distorts market prices. Why does this matter? History tells us that economic downturns following financial crises are deep and persistent. Smarter measurement of systemic risks and clearer understanding of the impacts of preventative government policies on asset markets helps to successfully avoid crises when possible and better navigate them when they strike
What is the upshot? Besides explaining the puzzling behavior of banking sector put options during the crisis, we demonstrate how information in the divergence between index options and the basket of options can be used to identify how guarantees affect banks’ cost of capital and, ultimately, their total market value.
Using a model of financial disasters matched to the behavior of crashes over history, they are able to attribute as much as half of the market value of the US financial sector during the crisis to the bailout guarantee. According to our estimates, the average government support of banking sector equity amounted to $0.65 billion before the crisis (2003-July 2007), and rose to $42.44 billion during the crisis (August 2007-June 2009), peaking at well over $150 billion along the way. At best we can only speculate about what kinds of resources the government consumes to implement this guarantee that props up bank stocks. But we can be certain that those resources ultimately come from taxpayer pockets.
This model also solves the problem of how to measure systemic risk in a world where the government distorts market prices. Why does this matter? History tells us that economic downturns following financial crises are deep and persistent. Smarter measurement of systemic risks and clearer understanding of the impacts of preventative government policies on asset markets helps to successfully avoid crises when possible and better navigate them when they strike
Source : IIPM Editorial, 2012.
An Initiative of IIPM, Malay Chaudhuri
and Arindam Chaudhuri (Renowned Management Guru and Economist).
For More IIPM Info, Visit below mentioned IIPM articles.
IIPM Best B School India
Management Guru Arindam Chaudhuri
Rajita Chaudhuri-The New Age Woman
IIPM's Management Consulting Arm-Planman Consulting
An Initiative of IIPM, Malay Chaudhuri
and Arindam Chaudhuri (Renowned Management Guru and Economist).
For More IIPM Info, Visit below mentioned IIPM articles.
IIPM Best B School India
Management Guru Arindam Chaudhuri
Rajita Chaudhuri-The New Age Woman
IIPM's Management Consulting Arm-Planman Consulting
