Athens: World Scientific and Engineering Academy and Society (W S E A S)
Many banks diversify their operations, either across different national markets (global diversification), across different borrowers by offsetting credit risks (hedging diversification), or both. Can multiple diversifications provide greater safety for banks? This paper aims to answer this question by using an option-based pricing model to formulate the default risk in bank equity returns under global and hedging diversifications. In particular, we apply Vassalou and Xing’s (2004) formula, which is a nonlinear option-based function of the default probability of an individual bank’s equity return. This formula is calculated using the contingent claim methodology of Black and Scholes (1973) and Merton (1974). We find that the extent of global diversification may provide greater safety for banks, but also that the extent of hedging diversification may not.
WSEAS Transactions on Mathematics 11(8), pp.667-678