Options may not provide funding for non-financial firms, but they are central to modern finance. Not only are millions traded daily, the valuation framework yields insight into corporate decisions with option-like dimensions. A good example is guarantees of bank deposits, which the Federal Deposit Insurance Corporation (FDIC) has offered since 1934. To see the option in deposit insurance, recall a “put” gives the holder the right, but not the obligation, to sell an asset at the strike price. Suppose, for example, you hold a put option on XYZ stock with a strike of $10. Should the stock price fall to $2, the put would be valuable because you could buy XYZ in the market, sell through the option contract, and pocket $8 on every share. If the price rises to $18, however, you would do better selling XYZ stock on the market (i.e., not exercising the put). This asymmetry––exercise inthe- money options but ignore out-of the- money options––has an important implication: An increase in the riskiness of the underlying asset can make an option more valuable. In the example above, the put is more valuable if the price of XYZ stock varies from $2 to $18 rather than from $9 to $11. Why? Because at any price above the strike––$11 or $18––the option is out of the money while exercising the put earns $8 per share when stock price falls to $2 but only $1 when it dips to $9. Deposit insurance offers the right, but not the obligation, to turn an underwater bank over to the FDIC. As long as the value of assets (mostly loans) exceeds liabilities (mostly insured deposits)––the CEO will not “put” the bank because shareholders would lose their equity (also called capital). But if loan losses drag the value of assets below liabilities––capital is negative––shareholders are wiped out, so the banker will hand the mess to the FDIC and walk away. The option to dump losses on the FDIC can affect a bank’s appetite for risk. Banks with healthy capital approach risky loans with caution because shareholders bear all the gains and losses. But when capital is nearly gone, risky loans become appealing because shareholders keep all the upside while the FDIC bears most of the downside–– another example of moral hazard (as explored in Focus on Ethics for chapter 16). This framework explains why U.S. bank failures were rare prior to the 1980s––government limitations on bank competition contained moral hazard by keeping profits high and capital strong. Then, deregulation and financial innovation ate away capital, spurring bankers to take more risk. Between 1934 and 1981, on average 13 U.S. banks failed each year––compared with 255 per year from 1982 to 1992. Regulators try to keep bankers from playing “heads I win, tails the FDIC loses” with capital requirements (including “stress testing” the preparedness of large banks for a serious recession or financial crisis), risk-based deposit-insurance premiums, and regular examinations. When asked why he robbed banks, Willie Sutton is said to have answered, “because that’s where the money is.” Bank regulators keep a close eye on capital and asset risk because that’s where the value of the put is.

a. How should a bank manager weigh her ethical duty to shareholders to “game” regulations to increase value of the put option in deposit insurance against her duty as a citizen not to saddle taxpayers with the losses?

b. Outside the financial services industry, debt and the limited liability structure of a corporation give managers a put option similar to the one the FDIC gives banks. If a firm’s investments turn out poorly, managers, on behalf of shareholders, can “put” the firm’s asset in the hands of lenders and walk away by going bankrupt. How does this influence the risk-taking incentives of managers, and what can bondholders do about it?