Assessing Solvency of Financial Institutions: An Option-theoretic Approach

In this paper, we quantify the subtle concepts of soundness and safety of financial institutions through option pricing theory. This approach permits to intuit many solvency issues, including capital adequacy, financial strain or distress, balance sheet rebuilding and critical recapitalization, through private capital injections or government rescue programs. Numerical examples to implement the involved calculations are provided to illustrate the economic principles that underpin many governmentsponsored rescue plans, such as the Troubled Assets Relief Program (TARP) in the U.S. This option approach applies easily to the general topic of capital structure decisions and thereby improves upon the static theory which is usually limited to trade-off between tax benefits and bankruptcy costs.