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The pitfalls in inferring risk from financial market data

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  • Robert R. Bliss

Abstract

This paper examines two qualitative rules of thumb, frequently invoked in discussions of bank regulatory policy. The first, that equity holders prefer more risk to less, derives from a result in option pricing theory, that an option's value increases monotonically with the riskiness of the underlying asset. This result is shown to depend on very restrictive assumptions regarding the underlying assets return distribution and the type of option being considered. These restrictive assumptions do not generally obtain in practice. The second rule of thumb is that bondholders' and deposit insurers' interests are aligned. The paper shows that, in fact, their interests can diverge in the sense that bondholders and deposit insurers will not necessarily agree on the relative riskiness of different banks or bank portfolios. The conclusion of this paper is that rules of thumb can be misleading. Furthermore, the concept of risk is shown to be model and agent specific.

Suggested Citation

  • Robert R. Bliss, 2000. "The pitfalls in inferring risk from financial market data," Working Paper Series WP-00-24, Federal Reserve Bank of Chicago.
  • Handle: RePEc:fip:fedhwp:wp-00-24
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    Cited by:

    1. García-Vega, María & Guariglia, Alessandra & Spaliara, Marina-Eliza, 2012. "Volatility, financial constraints, and trade," International Review of Economics & Finance, Elsevier, vol. 21(1), pages 57-76.
    2. Rong Fan & Joseph Haubrich & Peter Ritchken & James Thomson, 2003. "Getting the Most Out of a Mandatory Subordinated Debt Requirement," Journal of Financial Services Research, Springer;Western Finance Association, vol. 24(2), pages 149-179, October.
    3. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2006. "Equity and Bond Market Signals as Leading Indicators of Bank Fragility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 399-428, March.
    4. Eric Rasmusen, 2004. "When Does Extra Risk Strictly Increase the Value of Options?," Finance 0409004, EconWPA.
    5. Mark Flannery, 2001. "The Faces of “Market Discipline”," Journal of Financial Services Research, Springer;Western Finance Association, vol. 20(2), pages 107-119, October.
    6. John Krainer & Jose A. Lopez, 2008. "Using Securities Market Information for Bank Supervisory Monitoring," International Journal of Central Banking, International Journal of Central Banking, vol. 4(1), pages 125-164, March.
    7. Reint Gropp & Jukka M. Vesala & Giuseppe Vulpes, 2004. "Market indicators, bank fragility, and indirect market discipline," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 53-62.
    8. John Krainer & Jose A. Lopez, 2003. "How might financial market information be used for supervisory purposes?," Economic Review, Federal Reserve Bank of San Francisco, pages 29-45.

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    Keywords

    Bonds ; Options (Finance) ; Stocks;

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