A barrier option framework for bank interest margin management under anticipatory regret aversion
AbstractThis paper proposes a framework for bank equity valuation based on a path-dependent, barrier option model. A direct implication of this framework is that bank equity will be priced as a down-and-out call option. Using this approach, we examine how bank interest margin, i.e., the spread between the loan rate and the deposit rate, is determined when a bank is regret-averse. Regret-averse preferences are characterized by a down-and-in call, which is specified as the difference between a standard call and a down-and-out call. The model demonstrates how anticipatory regret aversion and the default barrier jointly determine an optimal bank interest margin decision. We find that a bank interest margin with a low level of default barrier is negatively related to anticipatory regret aversion and to the default barrier. Regret aversion and default barriers make a bank less prudent and more prone to risk-taking, thereby adversely affecting the stability of the banking system.
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Bibliographic InfoArticle provided by Elsevier in its journal Economic Modelling.
Volume (Year): 33 (2013)
Issue (Month): C ()
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Web page: http://www.elsevier.com/locate/inca/30411
Bank interest margin; Regret aversion; Barrier option; Bank equity valuation;
Find related papers by JEL classification:
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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