Was the Writing on the Wall? An Options Analysis of the 2008 Lehman Brothers Crisis

Zhirong Chen and Wai Mun Fong

Volume 10, Number 4, Fourth Quarter 2012

This paper uses risk neutral densities (RNDs) of stock options to investigate the markets perceptions of crash risk in the recent U.S. subprime crisis. RNDs were estimated using the double lognormal method for the S&P 500 market index, Lehman Brothers, Merrill Lynch and Goldman Sachs. We find strong evidence of bimodality in the RND of Lehman Brothers and Merrill Lynch as early as April 2008. In contrast, no evidence of bimodality was found for either Goldman Sachs or the S&P 500 index. These results vindicate the usefulness of the RND as a forecasting tool in extreme market conditions.