This paper seeks to explain the combination of explicit and implicit pricing for deposit insurance employed by the FDIC. Essentially, the FDIC sells two products—insurance and regulation. To span the product space, it must and does set two prices. We argue that the need to establish regulatory disincentives to bank risk‐taking is the heart of the controversy over the adequacy of bank capital and that the ability to close risky banks before exhausting their charter value (i.e., the value of their right to continue in business) stands at the center of these disincentives and in front of the FDIC's insurance reserves.

In this paper we examine the household's option to prepay or call a standard fixed-rate mortgage. Results based on simulation indicate that the value of this option is sensitive to the expected path of interest rates, the variation around that path, risk aversion and refinancing costs.Unfortunately, efforts to estimate the interest rate process (by us and by previous authors) have met with only limited success, and uncertainty exists regarding the degree of risk aversion and the magnitude of refinancing costs.Thus we conclude that the application of contingent-claims methodology to options on bonds is conceptually more difficult and operationally less reliable than is the analogous application to options on stocks.Despite these reservations concerning the use of our model as a technique for absolute valuation, preliminary findings on the effects of changes in mortgage contract design on the value of the prepayment option are encouraging.For example, our estimate of the relative values of the call options on 30-and 15-year mortgages and on level-payment and graduated-payment mortgages appear to be reasonably robust with respect to specifications of the interest rate process and the other parameters.These findings suggest that our model may be of considerable use within the context of relative or comparative valuation.A number of recent studies have attempted to price the prepayment or call option in mortgage contracts (Dunn and Mcconnell, 1981a and b) or limitations on this option (Dietrich et. ad., 1983). These studies: (1) assume that the spot rate of interest follows a mean-reverting process with a constant-elasticity standard deviation, (2) assign parameter values to the mean-reverting spot rate, the elasticity and scale of the standard deviation, the speed of adjustment and the "market price of risk", (3) assume zero tax rates and (4) calculate prices for the call option or limitations upon it! These studies suggest considerable confidence in the magnitudes of most, if not all, of the key parameters. Dunn and Mcconnell (1981b, p. 606) report that the parameter values used in their simulations were "similar to those estimated by Ingersoll" in an unpublished paper (1976) and did not report sensitivity results. The absence of such results could be taken as an indication that their model was sufficiently robust to permit reasonable inferences from the selected simulation results tabulated and reported. Dietrich, et. a1, too, specify values with no discussion. Unfortunately, there is substantial disagreement regarding many of these parameter values, as a comparison of the assumptions underlying Dunn-Mcconnell and Dietrich et. al. makes clear, and the results of these analyses are quitesensitive to a number of parameter values, consideration of the speed at one were uncertain regarding the time path of one of these parameters (interest rate volatility or the market price of risk, for example) , but fairly certain of the others, and were willing to posit market efficiency, then one could extract a time series on ...

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This paper seeks to explain the combination of explicit and implicit pricing for deposit insurance employed by the FDIC. Essentially, the FDIC sells two products-insurance and regulation. To span the product space, it must and does set two prices. We argue that the need to establish regulatory disincentives to bank risk-taking is the heart of the controversy over the adequacy of bank capital and that the ability to close risky banks before exhausting their charter value (i.e., the value of their right to continue in business) stands at the center of these disincentives and in front of the FDIC's insurance reserves. JUST AS A BOOK shouldn't be judged by its cover, a government agency shouldn't be judged by the words behind its initials. With the FDIC (Federal DepositInsurance Corporation), the agency's name describes only part of its formal operations: the FDIC is quasi-governmental, has a regional structure and sells deposit insurance. However, the initials fail to convey the FDIC's critical place in the governmental regulatory structure as the sole federal overseer of the approximately 8900 state-chartered commercial banks that have chosen not to belong the Federal Reserve System.' Reflecting the Federal Reserve's membership problem, the number of these banks is growing year by year.Besides selling deposit insurance at bargain explicit rates, the FDIC performs four regulatory functions: (1) Entry regulation. It passes on new banks' applications for deposit insurance and on branch and merger proposals as well, thereby protecting the value of existing bank charters; (2) Examination. Two-thirds of FDIC employees are concerned with inspecting bank records and supervising managerial activity; (3) Regulation of deposit rates and conditions for withdrawal. By tradition, FDIC policies on these matters conform entirely with regulations applicable to Federal Reserve member banks; and (4) Disposition of failed banks. When an insured bank fails, the FDIC usually chooses not to liquidate it.2

A model is developed and utilized in this paper to value a life-of-loan interest-rate cap on an ARM that reprices monthly. The value of the cap is seen to depend importantly on both the slope of the term structure and the variance of the 1-month rate. However, the cap value is not sensitive to the source of the slope of the term structure - what precise combination of interest-rate expectations and risk aversion determined the slope. This insensitivity is fortunate because of the great difficulty of knowing at any point in time why the term structure is what it is.Given the variation in the slope of the term structure and the variance of the 1-month rate that occurred over the 1979-84 period, the addition to the coupon rate on a 1-month ARM that lenders should have charged for a 5% life-of-loan cap has ranged from 5 to 40 basis points. Copyright American Real Estate and Urban Economics Association.