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Introducing Liquidity Risk in the Contingent-Claim Analysis for the Banks

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  • Daniel Oda

Abstract

Traditional approaches to assess the default risk of a bank fail to recognize their basic operations, granting loans and receiving deposits from the public. The contingent claims approach (CCA) is an extension of the Black-Scholes (1973) and Merton (1974) models that calculate the credit risk of a company by characterizing the company’s equity as a call option on its assets. Although a bank can be understood as a firm, anks receive deposits and unlike a common debt, these have to be renewed before the maturity of the assets. This paper proposes a new approach to measure the default risk of a bank based on the CCA, but it includes a stochastic distress barrier in order to capture the funding volatility of the bank. This new framework provides a method to calculate the implied volatility the bank’s assets and their corresponding distance to distress (DD) and the correlation between assets and deposits returns. This methodology is applied to the Chilean banking system in the period of 2003-2012. The results show that there was an important decrease of the DD that coincides with the increment in the funding volatility during the recent crisis.

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 681.

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Date of creation: Feb 2013
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Handle: RePEc:chb:bcchwp:681

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  1. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  2. Tse, Y K & Tsui, Albert K C, 2002. "A Multivariate Generalized Autoregressive Conditional Heteroscedasticity Model with Time-Varying Correlations," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 351-62, July.
  3. Jorge A. Chan-Lau, 2006. "Fundamentals-Based Estimation of Default Probabilities: A Survey," IMF Working Papers 06/149, International Monetary Fund.
  4. Jorge A. Chan-Lau & Toni Gravelle, 2005. "The End," IMF Working Papers 05/231, International Monetary Fund.
  5. Reint Gropp & Jukka Vesala & Giuseppe Vulpes, 2002. "Equity and bond market signals as leading indicators of bank fragility," Conference Series ; [Proceedings], Federal Reserve Bank of Boston.
  6. Merxe Tudela & Garry Young, 2003. "A Merton-model approach to assessing the default risk of UK public companies," Bank of England working papers 194, Bank of England.
  7. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  8. Alfaro, Rodrigo & Silva, Carmen Gloria, 2010. "Stock Index Volatility: the case of IPSA," MPRA Paper 25906, University Library of Munich, Germany, revised 31 Mar 2010.
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