Risk Assessment and Market Valuation of Indian Banking System: Black-Scholes Model

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Ravi Kumar ravikum@iitk.ac.in Indian Institute of Technology, Kanpur

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Project Under Dr. Surajit Sinha Professor of Economics Indian Institute of Technology, Kanpur

Objective
The riskiness of banks equity and their assets are two main measures for the valuation of bank. One of the most important innovations in financial engineering has been made by Black and Scholes and Merton in 1973. They have shown that it is possible to model banks equity as a call option on the banks asset. This paper will use Black-Scholes option valuation approach to measure the market value and volatility of bank assets for the random sample of 8 private sector and 13 public sector banks. The data used in this project is from March 2004 to March 2013. Further Z-score for each individual bank are calculated for period before and after 2008. Z-score will give the idea about the impact of global recession on Indian banks. Also I will calculate the Z score for period before and after 2009 to see the impact of Euro zone crisis.

1. Introduction
India is fourth largest economy in the world and according to one of the research work by Goldman Sachs, India will be third largest economy of the world by 2030 after China and USA. Banking sector in India has got the pace after the liberalization and globalization of 1990. After this period banks became more market oriented and started focusing more on stability and efficiency. It is important for banks to be financially sound as it not only carry out the financial activity but also carry the trust and confidence of people. Bank failure could create panic among the financial system and can send shocks in other financial institutions. 2008 global recession is fresh example of such a situation; hence an urgent need arises to check the financial health of banks. Traditionally bank valuation was based on accounting data instead of market data. Recently quantitative tools are developed and market data are used to look at the financial health of the banks. Recent economic crisis has created urgency to calculate the riskiness of both assets and equity of the banks as predicting the bank failure well in advance is good for both system and public as a whole.

2. Literature review
Amel et al (2011) discuss that bank failures could happen even despite capital adequacy norms maintenance and balance sheet solvency. These might arise due to sudden shocks in the liquidity positions of banks. Hull et al (2004) also apply Mertons Model (1974) propose a methodology for estimating the model's parameters from the implied volatilities of options on the equity as a call option on its assets. Data that they used is from the credit default Swap market and compare their implementation of Mertons model to traditional approach. Liu et al (2004) apply asset-valuation model developed by Rabinovitch (1989 ) to Canadian banks. The model is an extension of the Merton (1973) option-pricing model with incorporation of stochastic interest rates. They further introduce a measure of distance to default known as Zscore using the values of asset, volatility and the face value of debt. Giammarino et al (1989) estimate the market value of assets for Canadian banks using an option-pricing model and conclude that there is a substantial difference between a banks market value and its book value. This value considerably increases during banks failure.

3. Methodology and Variables

We will use Black-Scholes model to evaluate banks assets. Consider a bank acquires a portfolio at time t=0 and fund it with liabilities with face value D. this portfolio matures at time t=T, compound rate of interest=r, and the value of bank equity=E0. Now, At time t=T, Liability to depositors = Dert ; Market value of banks assets = VT; If VT < Dert at time t=T, then bank will default and value of equity is =0. If VT > Dert then bank will repay its liabilities. the value of its equity at time T will be VT - Dert. The payoff can be written as:

Max(0, VT - Dert); Generally due to high bankruptcy cost bank simply does not declare bankrupt the moment its liabilities exceeds its assets. So, a term (lambda) is introduced whose value is set by the regulatory authority (from the working paper of Liu, Papakirykos and Yuan, 2004). For the value of =1, the moment liabilities exceeds its assets, the bank will declare bankruptcy. cn tke any valur between 0< <1. So, Dert is the critical value below which it is optimal for bank to declare bankrupt. Therefore, the maximum payoff can now became: max(0, VT - Dert); For the value of equity=E0, the risk free rate = rf , and volatility of the asset is v then Black-Scholes model gives the value of Equity at time 0 (today)as: E0 = V0 N(d1) D.e-rf.t. N(d2) Where, d1 = [ ln(V0/D) + (rf + v2/2)T ] /v; d2 = [ ln(V0/D) + (rf - v2/2)T ] /v; . (1)

........ (2)

Equation (1): To calculate equation (1) we require V0 , d1 and d2 . Equation (2): To calculate d1 and d2 we require v . we can calculate this through Ito's lemma, E.E0 = dE/dV . v . V0 or, E = N(d1). v . V0/E0

................. (3)

And Z score (Distance-to-default) formula is given as: [1- (1-ET/VT)]/ v

Table 1: Variables used in Black Scholes option pricing model parameter E0 V0 T rf D In context of financial option Market capitalization of bank equity at Option price time 0 Value of bank at time 0 (today) Stock price 1 year Time to expiration Annual Average of 90 day T-bill rates Risk free rate of return Total Debt (Short term debt and Long Strike price term debt) Volatility of equity at time 0 Volatility of Asset at time 0 Volatility of return on stock & Normal cumulative distributions which gives us the range of likelihood of real option being viable before expiration date. In context of real option

v N(d1) N(d2)

Table 2: list of public sector and private sector bank selected for project Public sector State bank of India Bank of Baroda Punjab National Bank Canara Bank Bank of India IDBI Bank Oriental bank of Commerce Syndicate Bank Allahbad Bank Indian overseas Bank Andhra Bank UCO Bank Union Bank Private sector HDFC Bank ICICI Bank Axis Bank Kotak Mahindra Bank(KMB) Indusland Bank Ing Vysya Bank Jammu and Kashmir Bank

4. Data sources
RBI website (rbi.org). Indian Banks Association (http://www.iba.org.in)

References
Altman, E.I. (1977). The Z-score Bankruptcy Model: Past, Present, and Future, New York: Amel-Zadeh, A. and Meeks, G. (2011). Bank failure, mark-to-market and the financial crisis.Working Paper Series available on SSRN Government of India, (2004).Economic Survey: 200304. Ministry of Finance (EconomicDivision), New Delhi. Liu Y., Papakirykos, E., Yuan, M. (2004). Market Valuation and Risk Assessment of Canadian Banks. Bank of Canada: Working Paper, 2004-34. Merton, R.C. (1973). Theory of Rational Option Pricing. Bell Journal of Economics and Management Science, Vol. 4, pp. 14183.