IDEAS home Printed from https://ideas.repec.org/p/sek/iefpro/0401522.html
   My bibliography  Save this paper

Assessing Solvency of Financial Institutions: An Option-theoretic Approach

Author

Listed:
  • Jie Dai

    (FISMS, Sobey School of Business, Saint Mary's University)

Abstract

In this paper, we quantify the subtle concepts of soundness and safety of financial institutions through option pricing theory. This approach permits to intuit many solvency issues, including capital adequacy, financial strain or distress, balance sheet rebuilding and critical recapitalization, through private capital injections or government rescue programs. Numerical examples to implement the involved calculations are provided to illustrate the economic principles that underpin many governmentsponsored rescue plans, such as the Troubled Assets Relief Program (TARP) in the U.S. This option approach applies easily to the general topic of capital structure decisions and thereby improves upon the static theory which is usually limited to trade-off between tax benefits and bankruptcy costs.

Suggested Citation

  • Jie Dai, 2014. "Assessing Solvency of Financial Institutions: An Option-theoretic Approach," Proceedings of Economics and Finance Conferences 0401522, International Institute of Social and Economic Sciences.
    • Handle: RePEc:sek:iefpro:0401522
    as

    Download full text from publisher

    File URL: https://iises.net/proceedings/2nd-economics-finance-conference-vienna/table-of-content/detail?cid=4&iid=10&rid=1522
    File Function: First version, 2014
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Fabio Panetta & Thomas Faeh & Giuseppe Grande & Corrinne Ho & Michael R King & Aviram Levy & Federico M Signoretti & Marco Taboga & Andrea Zaghini, 2009. "An assessment of financial sector rescue programmes," BIS Papers, Bank for International Settlements, number 48.
    2. ., 2009. "Accountability and Governance," Chapters, in: An Islamic Perspective on Governance, chapter 8, Edward Elgar Publishing.
    3. ., 2009. "Governance and Corruption," Chapters, in: An Islamic Perspective on Governance, chapter 9, Edward Elgar Publishing.
    4. ., 2009. "Perspectives on Governance," Chapters, in: An Islamic Perspective on Governance, chapter 1, Edward Elgar Publishing.
    5. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    6. ., 2009. "Justice: The Inner Core of Governance," Chapters, in: An Islamic Perspective on Governance, chapter 3, Edward Elgar Publishing.
    7. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    8. Pascal Francois, 2004. "Capital Structure and Asset Prices: Some Effects of Bankruptcy Procedures," The Journal of Business, University of Chicago Press, vol. 77(2), pages 387-412, April.
    9. Broadie, Mark & Kaya, Özgür, 2007. "A Binomial Lattice Method for Pricing Corporate Debt and Modeling Chapter 11 Proceedings," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(2), pages 279-312, June.
    10. Ronn, Ehud I & Verma, Avinash K, 1986. "Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance, American Finance Association, vol. 41(4), pages 871-895, September.
    11. Schaefer, Stephen M. & Strebulaev, Ilya A., 2008. "Structural models of credit risk are useful: Evidence from hedge ratios on corporate bonds," Journal of Financial Economics, Elsevier, vol. 90(1), pages 1-19, October.
    12. ., 2009. "Financing Methods for Government Bodies," Chapters, in: An Islamic Perspective on Governance, chapter 7, Edward Elgar Publishing.
    13. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    14. repec:bla:jfinan:v:59:y:2004:i:2:p:831-868 is not listed on IDEAS
    15. Brian Kantor & Christopher Holdsworth, 2010. "Lessons from the Global Financial Crisis (Or Why Capital Structure Is Too Important to Be Left to Regulation)," Journal of Applied Corporate Finance, Morgan Stanley, vol. 22(3), pages 112-122, June.
    16. Sreedhar T. Bharath & Tyler Shumway, 2008. "Forecasting Default with the Merton Distance to Default Model," The Review of Financial Studies, Society for Financial Studies, vol. 21(3), pages 1339-1369, May.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Giesecke, Kay & Longstaff, Francis A. & Schaefer, Stephen & Strebulaev, Ilya, 2011. "Corporate bond default risk: A 150-year perspective," Journal of Financial Economics, Elsevier, vol. 102(2), pages 233-250.
    2. Simmons, Geoff & Giraldo, Jorge Esteban Diez & Truong, Yann & Palmer, Mark, 2018. "Uncovering the link between governance as an innovation process and socio-economic regime transition in cities," Research Policy, Elsevier, vol. 47(1), pages 241-251.
    3. Silva, Felipe Bastos Gurgel, 2021. "Fiscal Deficits, Bank Credit Risk, and Loan-Loss Provisions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 56(5), pages 1537-1589, August.
    4. Kay Giesecke & Francis A. Longstaff & Stephen Schaefer & Ilya Strebulaev, 2010. "Corporate Bond Default Risk: A 150-Year Perspective," NBER Working Papers 15848, National Bureau of Economic Research, Inc.
    5. Zhijian (James) Huang & Yuchen Luo, 2016. "Revisiting Structural Modeling of Credit Risk—Evidence from the Credit Default Swap (CDS) Market," JRFM, MDPI, vol. 9(2), pages 1-20, May.
    6. Jobst, Andreas A., 2014. "Measuring systemic risk-adjusted liquidity (SRL)—A model approach," Journal of Banking & Finance, Elsevier, vol. 45(C), pages 270-287.
    7. Stefan Nagel & Amiyatosh Purnanandam, 2020. "Banks’ Risk Dynamics and Distance to Default," The Review of Financial Studies, Society for Financial Studies, vol. 33(6), pages 2421-2467.
    8. Jie Cao & Amit Goyal & Xiao Xiao & Xintong Zhan, 2023. "Implied Volatility Changes and Corporate Bond Returns," Management Science, INFORMS, vol. 69(3), pages 1375-1397, March.
    9. Dalla Valle, Luciana & De Giuli, Maria Elena & Tarantola, Claudia & Manelli, Claudio, 2016. "Default probability estimation via pair copula constructions," European Journal of Operational Research, Elsevier, vol. 249(1), pages 298-311.
    10. Viral Acharya & Sergei A. Davydenko & Ilya A. Strebulaev, 2012. "Cash Holdings and Credit Risk," The Review of Financial Studies, Society for Financial Studies, vol. 25(12), pages 3572-3609.
    11. Zhang, Jinqing & He, Liang & An, Yunbi, 2020. "Measuring banks’ liquidity risk: An option-pricing approach," Journal of Banking & Finance, Elsevier, vol. 111(C).
    12. Hoi Ying Wong & Tsz Wang Choi, 2009. "Estimating default barriers from market information," Quantitative Finance, Taylor & Francis Journals, vol. 9(2), pages 187-196.
    13. Bougias, Alexandros & Episcopos, Athanasios & Leledakis, George N., 2022. "The role of asset payouts in the estimation of default barriers," International Review of Financial Analysis, Elsevier, vol. 81(C).
    14. Grass, Gunnar, 2010. "The impact of conglomeration on the option value of equity," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 3010-3024, December.
    15. Jaewon Choi & Matthew P. Richardson & Robert F. Whitelaw, 2014. "On the Fundamental Relation Between Equity Returns and Interest Rates," NBER Working Papers 20187, National Bureau of Economic Research, Inc.
    16. Botsch, Matthew & Vanasco, Victoria, 2019. "Learning by lending," Journal of Financial Intermediation, Elsevier, vol. 37(C), pages 1-14.
    17. Atkeson, Andrew G. & Eisfeldt, Andrea L. & Weill, Pierre-Olivier, 2017. "Measuring the financial soundness of U.S. firms, 1926–2012," Research in Economics, Elsevier, vol. 71(3), pages 613-635.
    18. Ho, Kung-Cheng & Yen, Huang-Ping & Lu, Canyi & Lee, Shih-Cheng, 2023. "Does information disclosure and transparency ranking system prevent the default risk of a firm?," Economic Analysis and Policy, Elsevier, vol. 78(C), pages 1089-1105.
    19. Oliver Levine & Youchang Wu, 2021. "Asset Volatility and Capital Structure: Evidence from Corporate Mergers," Management Science, INFORMS, vol. 67(5), pages 2773-2798, May.
    20. Joshua D. Anderson & John E. Core, 2018. "Managerial Incentives to Increase Risk Provided by Debt, Stock, and Options," Management Science, INFORMS, vol. 64(9), pages 4408-4432, September.

    More about this item

    Keywords

    Soundness and safety of financial institutions; Capital adequacy; Recapitalization;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:sek:iefpro:0401522. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Klara Cermakova (email available below). General contact details of provider: https://iises.net/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.