Hanno Lustig

May 30, 2012

Hanno Lustig Wins JP Morgan Best Paper Award

The award will be presented this month by the Western Finance Association

LOS ANGELES -- Associate Professor Hanno Lustig has been awarded the JP Morgan Award for the Best Paper on Financial Institutions and Markets from the Western Finance Association for his paper, "Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees." Lustig will share a $5000 cash prize with co-authors Bryan Kelly and Stijn Van Nieuwerburgh.

"The idea of the paper is very simple," Lustig says. "If there are government guarantees that protect financial institutions and their shareholders, then we could look at option markets to learn how big these guarantees are. That's important because, if they're too big, we worry that they're going to distort incentives and institutions may take on risks they ordinarily wouldn't."

So they looked at option markets. "Suppose the government puts a floor on the stock market value of the financial sector and it's not willing to let the market cap of the financial sector fall below that floor," he says. "Well, that should become apparent in option markets because if you look at the cost of a put option, that cost should actually go down when that guarantee kicks in because the government is eliminating some of the downside for private investors. So privately provided insurance against big drops in the financial sector should become cheaper. And that's what we find. We find it becomes cheaper to insure against big drops in the financial sector during a crisis, which is surprising because a lot of people would probably think the exact opposite."

"So this is evidence of the footprint of the government, and I use that term broadly to include the Treasury, the Federal Reserve and other regulators. Their footprint shows up in option markets. So the paper goes through some exercises to show that this is really anomalous. We can conclude that the government seems to distort risk-taking incentives."

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