Contingent claim analysis and Minsky’s financial instability hypothesis

Abstract

The idea of interrelated balance sheets is an integral part of modern Post-Keynesian Stock-Flow Consistent modeling which emphasizes the interaction between the financial and the real side of the economy. However, the same idea is used in the growing literature on Contingent Claim Analysis as a novel tool that can be used by regulatory authorities in their evaluation of risk assumed by financial institutions. This paper combines these approaches with Minsky’s Financial Instability Hypothesis and its focus on financial fragility with respect to the dynamics of the financial structure of economic units through the cycle. The main contribution of our paper is to show that Contingent Claims Analysis within a Minskyan framework might become a powerful regulatory tool and a valuable addition to Post-Keynesian Stock-Flow Consistent modeling since, through its provision for non-linearities and market volatility, it provides a realistic forward-looking depiction of the interplay between the real and financial side of the economy.

Keywords:

• Financial instability hypothesis
• contingent claims analysis
• balance sheets analysis

JEL CLASSIFICATION:

• B52
• C63
• E12
• G21

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 The Financial Instability Hypothesis is of course well known to the readers of this Journal. However, we consider this brief review useful for two reasons. Firstly, it will improve the readability of this article for researchers outside the heterodox community who are interested in understanding how the Minskian framework enhances and improves the CCA approach. Secondly, since our aim is to think of the CCA approach in terms of Minsky’s Financial Instability Hypothesis we think that such a brief reminder is not redundant even for the knowledgeable.

2 For a constant debt level B, this is equivalent to growing net worth or equity. However, a sustainable growth of the firm’s assets and profitability would imply rising operating income rather than windfall capital gains. We would like to thank an anonymous referee for bringing this point to our attention.

3 We assume that the growth rate of the asset value is equal to the risk-free interest rate.

4 This is an example of a changing probability distribution due to increased perceived risk by both borrowers and lenders facing a more uncertain future. It is in fact an example of rising uncertainty of risk assumed (Griffith-Jones et al. 2022). Furthermore, note that for a given B, all uncertainty comes from the variability of A.

5 Of course, market values also depend on expected capital gains. If these latter overstate future income streams then this adds further to financial instability thus, rising the volatility σ of the asset value in the model. We would like to thank an anonymous referee for pointing out this issue.

6 Following Tymoigne (2014) we may need to differentiate between income-based Ponzi finance and asset-based Ponzi finance. Income-based Ponzi financing may refer to capital assets with long gestation period when income is not enough to cover debt payments until a sufficient time period passes by while asset-based Ponzi financing or pyramid schemes refer to the case in which debt payments can only be serviced if assets are sold at a high enough price to yield a profit. In our case, Asset-based Ponzi financing is expected to be deep-in-the-money while income-based Ponzi financing may be in-the-money, whenever refinancing is needed to cover debt payments, or just out-of-the-money when income receipts are expected to reach a level high enough to service debt payments. We would like to thank an anonymous reviewer for suggesting this particular distinction between income-based and asset-based Ponzi finance and its connection to the option moneyness.

7 The transmission to the government would depend on the nature of the debt involved. If the government is monetarily sovereign, it can absorb any loss it wants and run deep negative net worth on a chronic basis. We would like to thank an anonymous referee for pointing this out.

8 Equity volatility can be computed using historical log returns or can be derived from equity options if these are available. The Equations (4) and (5) are solved numerically using an iteration procedure, i.e., obtaining the values of asset volatility and asset value that simultaneously solve the two equations. In empirical applications the debt threshold is usually set equal to the book value of debt with maturity up to 12 months plus half the value of the long-term debt.

9 As in the case of the financial sector, in empirical applications the foreign debt threshold is usually set equal to the value of foreign debt with maturity up to 12 months plus half the value of the long-term foreign debt.