Alternative Valuation of the Cost of Deposit Insurance: An Application of Option Pricing Model with Stochastic Volatility

Abstract

This paper first introduces the theoretical application of Option Pricing Model with stochastic volatility to the valuation of deposit insurance premium. We compare our model with Merton's (1977) original version in which volatility is assumed as constant and show that Merton's model is just a special case of our generalized pricing model. Since Black-Scholes model frequently undervalues deep in- and out-of-the-money option, we expect that future empirical studies using this pricing model with stochastic volatility could provide higher estimates of deposit insurance premiums and resolve the controversy between the previous empirical finding of overcharged premiums and the insolvent situation of deposit insurance funds.