Unlimited Liabilities, Reserve Capital Requirements and the Taxpayer Put Option

41 Pages Posted: 28 Jan 2010 Last revised: 10 May 2010

See all articles by Ernst Eberlein

Ernst Eberlein

University of Freiburg

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Date Written: April 26, 2010

Abstract

When firms access unbounded liability exposures and are granted limited liability, then an all equity firm holds a call option, whereby it receives a free option to put losses back to the taxpayers. We call this option the taxpayer put, where the strike is the negative of the level of reserve capital at stake in the firm. We contribute by (i) valuing this taxpayer put, and (ii) determining the level for reserve capital. Reserve capital levels are designed to mitigate the adverse incentives for unnecessary risk introduced by the taxpayer put at the firm level. In our approach, the level of reserve capital is set to make the aggregate risk of the firm externally acceptable, where the specific form of acceptability employed is positive expectation under a concave distortion of the cash flow distribution. It is observed that in the presence of the taxpayer put, debt holders may not be relied upon to monitor risk as their interests are partially aligned with equity holders by participating in the taxpayer put. Further, it leads to an equity pricing model associated with a market discipline that punishes perceived cash shortfalls.

Keywords: Concave Distortions, Spread Options, Correlated Levy Processes

JEL Classification: G1, G12, G13

Suggested Citation

Eberlein, Ernst and Madan, Dilip B., Unlimited Liabilities, Reserve Capital Requirements and the Taxpayer Put Option (April 26, 2010). Available at SSRN: https://ssrn.com/abstract=1540813 or http://dx.doi.org/10.2139/ssrn.1540813

Ernst Eberlein

University of Freiburg ( email )

Department of Mathematical Stochastics
Eckerstrasse 1
D-79104, Freiburg
Germany
++49 761 203 5660 (Phone)
++49 761 203 5661 (Fax)

Dilip B. Madan (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

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