The pitfalls in inferring risk from financial market data
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.
|Date of creation:||2000|
|Date of revision:|
|Contact details of provider:|| Postal: |
Web page: http://www.chicagofed.org/Email:
More information through EDIRC
|Order Information:|| Web: http://www.chicagofed.org/webpages/publications/print_publication_order_form.cfm Email: |
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Robert R. Bliss, 2001. "Market discipline and subordinated debt: a review of some salient issues," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 24-45.
- Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
- Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
- Douglas D. Evanoff & Larry D. Wall, 2000.
"Subordinated debt and bank capital reform,"
2000-24, Federal Reserve Bank of Atlanta.
- Black, Fischer & Scholes, Myron S, 1972. "The Valuation of Option Contracts and a Test of Market Efficiency," Journal of Finance, American Finance Association, vol. 27(2), pages 399-417, May.
- Yaacov Z. Bergman & Bruce D. Grundy & Zvi Wiener, .
"General Properties of Option Prices (Revision of 11-95) (Reprint 058),"
Rodney L. White Center for Financial Research Working Papers
01-96, Wharton School Rodney L. White Center for Financial Research.
- Yaacov Z. Bergman & Bruce D. Grundy & Zvi Wiener, . "General Properties of Option Prices (Revision of 11-95) (Reprint 058)," Rodney L. White Center for Financial Research Working Papers 1-96, Wharton School Rodney L. White Center for Financial Research.
- Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
- Jagannathan, Ravi, 1984. "Call options and the risk of underlying securities," Journal of Financial Economics, Elsevier, vol. 13(3), pages 425-434, September.
- Peter Ritchken & James Thomson & Ray DeGennaro & Anlong Li, 1991.
"On flexibility, capital structure, and investment decisions for the insured bank,"
9110, Federal Reserve Bank of Cleveland.
- Ritchken, Peter & Thomson, James B. & DeGennaro, Ramon P. & Li, Anlong, 1993. "On flexibility, capital structure and investment decisions for the insured bank," Journal of Banking & Finance, Elsevier, vol. 17(6), pages 1133-1146, December.
- Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
- Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October.
- Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
- Merton, Robert C, 1978.
"On the Cost of Deposit Insurance When There Are Surveillance Costs,"
The Journal of Business,
University of Chicago Press, vol. 51(3), pages 439-52, July.
- Merton, Robert C., 1977. "On the cost of deposit insurance when there are surveillance costs," Working papers 903-77., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, volume 1, number 5474.
- Bergman, Yaacov Z & Grundy, Bruce D & Wiener, Zvi, 1996. " General Properties of Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1573-1610, December.
When requesting a correction, please mention this item's handle: RePEc:fip:fedhwp:wp-00-24. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Bernie Flores)
If references are entirely missing, you can add them using this form.