THE VALUATION OF DEPOSIT INSURANCE USING ALTERNATIVE OPTION-PRICING MODELS

This study uses two alternative option-pricing models to develop numerical estimates of the value of deposit insurance for a sample of large bank/BHCs with actively-traded shares of common stock. Initial estimates are obtained using 1984 data and Marcus and Shaked's (1984) methodology, which is an application of Merton's (1977) model. In addition, a new option-pricing model is developed based upon the assumption of constant elasticity of variance (CEV). Using this CEV model developed by Cox and Ross (1976), estimates of deposit-insurance values are obtained and compared to those generated with the Marcus and Shaked methodology. Most importantly, both sets of results are subjected to sensitivity analysis. Although the models provide reasonable estimates of deposit-insurance values, the sensitivity of the values to errors in parameter estimation is so great that the practical usefulness of existing option-pricing models for valuing deposit insurance or judging the procedures or policies of government deposit-insurance agencies is questioned. As a result, the findings of Marcus and Shaked that deposit-insurance is overpriced is suspect.