Systematic risk and deposit insurance pricing: Based on market model and option pricing theory
China Finance Review International
ISSN: 2044-1398
Article publication date: 21 September 2017
Issue publication date: 11 October 2017
Abstract
Purpose
The purpose of this paper is to alleviate the moral hazard problem created by deposit insurance and therefore develop a deposit insurance pricing model explicitly considering systematic risk.
Design/methodology/approach
Using the market model, the authors introduce the systematic risk component consisting of market risk and beta risk. A closed-form solution for the authors’ pricing model is derived based on the option pricing framework.
Findings
Compared with the authors’, the pricing model that ignores systematic risk underestimates deposit insurance premium, and cannot cover the excessive loss created by systematic risk. To examine the effect of the systematic risk component on the deposit insurance premiums estimated by the authors’ model, this paper also provides empirical evidence from China by regression analysis. The results demonstrate that, in addition to the individual failure risk, the systematic risk component is properly priced and explicitly reflected in the authors’ model.
Research limitations/implications
More risk factors such as liquidity risk should be introduced in the pricing of deposit insurance.
Practical implications
Deposit insurance premiums estimated by the authors’ model can alleviate the moral hazard problem that banks have an incentive to take on excessive systematic risk, because substantial higher insurance premiums would be charged in doing so.
Originality/value
Applying the option pricing theory and market model, this paper develops a deposit insurance pricing model with explicit consideration of systematic risk. The systematic risk component contains not only the market volatility but also the sensitivity of market risk.
Keywords
Acknowledgements
This research is supported by the National Social Science Foundation of China (Grant Nos 12CGL020, 15XZZ011), the National Natural Science Foundation of China (Grant Nos 71371157, 71671145), and Service Science and Innovation Key Laboratory of Sichuan Province (Grant No. KL1704). The first author, Yaojie Zhang, presides over this foundation project.
Citation
Zhang, Y. and Shi, B. (2017), "Systematic risk and deposit insurance pricing: Based on market model and option pricing theory", China Finance Review International, Vol. 7 No. 4, pp. 390-406. https://doi.org/10.1108/CFRI-12-2016-0133
Publisher
:Emerald Publishing Limited
Copyright © 2017, Emerald Publishing Limited