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Competitively-Issued Convertible Bank Notes in a Theory of Finance: Earl Thompson Meets Fischer Black

  • Joshua R. Hendrickson EMAIL logo

Abstract

In this paper, I show the validity of and the relationship between two previously unrelated claims in monetary theory. The first claim, made by Earl Thompson, is that privately-issued bank notes pay a positive rate of return in a competitive equilibrium. The second claim, made by Fischer Black, is that it is possible to have a gold standard in which the gold reserves of the central bank are near zero. I show that both of these claims are correct under the assumption of complete markets and perfect commitment. The link between these claims is the Black-Scholes equation applied to convertible bank notes. In commodity-based monetary systems, bank notes are perpetual American options. I extend the model to consider the implications of a lack of commitment on the part of the bank and incomplete markets. I show that both arguments break down when banks lack commitment to redemption or markets are incomplete. I conclude with implications for macroeconomic theory.

JEL Classification: E42; E50

Corresponding author: Joshua R. Hendrickson, Department of Economics, University of Mississippi, 306 Odom Hall, University, MS, 38677, USA, E-mail:

Appendix

A.1 Proof of Proposition 1

Imagine that a bank issues n n bank notes denominated in N dollars. The bank’s assets consist of B dollars of risk-less bonds that earn a risk-free rate of return, r. It follows that dB rBdt. The bank also holds n c ounces of the commodity. It follows that the net worth, W, of the issuing bank can be written as

W = p n c + B n n v ( p )

Assuming that the quantity of the commodity and the quantity of bank notes are held constant, it follows that

d W = n c d p + d B n n d v

or

d W = ( n c μ p + r B n n μ v v ) d t + ( n c σ p n n σ v v ) d z

The bank can perfectly hedge its risk by choosing an optimal reserve ratio. Specifically, the bank can choose its reserve ratio such that

n c σ p n n σ v v = 0

Solving for the reserve ratio yields:

n c p n n v = σ v σ

When the bank chooses this reserve ratio, the net worth of the bank is given as

d W = ( n c μ p + r B n n μ v v ) d t

In other words, the net worth of the bank grows at certain rate. If this rate is lower than the risk-free rate, r, then it wouldn’t make sense for the bank to operate. If this rate is above the risk-free rate, r, then the banks could earn a positive profit from arbitrage without any risk. However, in a competitive banking system, banks would enter until the rate of return on the net worth of the bank is equal to the risk-free rate. Thus, in any equilibrium in which banks exist, the net worth of the bank evolves according to

d W = r W d t

Given the portfolio above, this implies that

d W = r ( p n c + B n n v ) d t

Thus, it must be true that

n c μ p + r B n n μ v v = r p n c + r B r n n v

Or,

n c μ p n n μ v v = r p n c r n n v

Dividing both sides by n n v yields

n c p n n v μ μ v = n c p n n v r r μ v r = n c p n n v ( μ r )

Plugging in the reserve ratio that perfectly hedges risk yields

μ v r σ v = μ r σ

Plugging in μ v and σ v from Equations (3) and (4), respectively, yields

1 v [ μ p v ( p ) + 1 2 σ 2 p 2 v ( p ) ] r 1 v σ p v ( p ) = μ r σ

Or,

μ p v ( p ) + 1 2 σ 2 p 2 v ( p ) r v ( p ) p v ( p ) = μ r

Re-arranging yields:

1 2 σ 2 p 2 v ( p ) + r p v ( p ) r v ( p ) = 0

This is the Black-Scholes (1973) equation for a perpetual American option. Given this equation, we need to verify parts (a), (b), and (c) of the proposition.

To do so, let’s conjecture that

v ( p ) = A p B

Plugging this function and the appropriate derivatives into the differential equation demonstrates that this is a solution if B is a solution to the following quadratic equation:

(5) 1 2 σ 2 B 2 + ( r 1 2 σ 2 ) B r = 0

This equation has one positive solution and one negative solution. The solution to the differential equation can be written as

v ( p ) = A 1 p B 1 + A 2 p B 2

where A 1 and A 2 are positive constants and B 1 is the positive solution and B 2 is the negative solution to Equation (5).

This can be simplified further by using economic theory. For example, in the hypothetical scenario in which the price of the commodity goes to zero, the option to purchase the commodity at a fixed price becomes worthless because the commodity becomes worthless and isn’t traded. The option to buy a worthless commodity is therefore also worthless. In other words, the ability to go to the bank and exchange one ounce of the commodity for K dollars is unlikely to be honored as the commodity loses all of its market value. This implies that

lim p 0 v ( p ) = 0

This requires that A = 0. As a result, the solution for v(p) is

(6) v ( p ) = A 1 p B 1

Also, at the precise price at which the option to buy the commodity is exercised, the individual is indifferent to holding the bank note and buying the commodity. Let p * denote the price at which the option to purchase the commodity is exercised. It follows that

v ( p * ) = ( p * K ) N K

where N is the denomination of the note and K is the strike price, or official price of the commodity. The conjectured solution implies that

A 1 ( p * ) B 1 = ( p * K ) N K A 1 = ( p * ) B 1 [ p * K ] N K

Substituting this expression for A 1 into Equation (6) provides a solution to the value as a function of the current price, the price when the option is exercised, the denomination, and the strike price:

v ( p ) = ( p p * ) B 1 [ p * K ] N K

To this point, I have referred to p * as the price of the commodity when the option is exercised. However, I have not yet determined this threshold for the price. The threshold can be determined through economic reasoning. A higher threshold increases the value of exercising at the exercise date. However, a higher threshold also reduces the present value of the option. The note holder wants to optimally balance this trade-off and can do so by choosing the threshold, p *, that maximizes v(p). The threshold is given as

(7) p * = ( B 1 B 1 1 ) K

Now recall that B 1 is the positive solution to Equation (5). Let’s write the solution in the form:

( B + λ 1 ) ( B + λ 2 ) = 0

It follows that

λ 1 λ 2 = 2 r σ 2

λ 1 + λ 2 = 2 r σ 2 1

It is straightforward to solve for λ 1 = −1 and λ 2 = 2 r σ 2 and therefore B 1 = 1. This is an important result because it will prove parts (a) and (b) of the proposition.

Consider first the implications for part (a) of the proposition. From the threshold for p shown in Equation (7), it follows that

lim B 1 1 p * =

This means that, in the absence of risk-free arbitrage, the option to redeem the bank note for the commodity is never exercised. This proves part (a).

For part (b) of the proposition, recall that

v ( p ) = ( p p * ) B 1 [ p * K ] N K

So, when B 1 = 1, it follows that

v ( p ) = ( p p * ) [ p * K ] N K = ( 1 K p * ) p N K

and therefore

v ( p ) = p N K

This proves part (b) of the proposition.[5]

Part (c) says that both the expected rate of return on the bank note and the expected rate of return on the commodity are equal to the real risk-free rate, r. Let’s start with the assumption that the expected rate of return on the bank note is r. Formally, this implies that

r = 1 d t E d v v

Or,

r v ( p ) = 1 d t E ( v ( p ) d p + 1 2 v ( p ) ( d p ) 2 )

Plugging in Equation (1) yields

(8) 1 2 σ 2 p 2 v ( p ) + μ p v ( p ) = r v ( p )

I have already shown that the solution for v(p) is v ( p ) = p N K . It follows that

v ( p ) = N K

v ( p ) = 0

Plugging these into Equation (8) yields:

μ = r

Thus, both the expected rate of return on the bank note and the underlying commodity are equal to the risk-free rate. This proves part (c) of the proposition and completes the proof.

A.2 Proof of Proposition 2

Recall that the value of the bank note is given as v(p). Given the probability of bankruptcy, it follows that

d v = v ( p ) d p + 1 2 v ( p ) ( d p ) 2 + ρ [ 0 v ( p ) ] d t

Plugging in Equation (1) yields

d v = [ μ p v ( p ) + 1 2 σ 2 p 2 v ( p ) ρ v ( p ) ] d t + σ p v ( p ) d z

or

d v v = μ ˆ v d t + σ v d z

where

μ ˆ v = 1 v [ μ p v ( p ) + 1 2 σ 2 p 2 v ( p ) ρ v ( p ) ]

and σ v is defined as in (4).

From Proposition 1, I know that in the absence of risk-free arbitrage it must be the case that

μ ˆ v r σ v = μ r σ

Plugging in the values for μ ˆ v and σ v yields

1 v [ μ p v ( p ) + 1 2 σ 2 p 2 v ( p ) ρ v ] r 1 v σ p v ( p ) = μ r σ

Simplifying yields

1 2 σ 2 p 2 v ( p ) + r p v ( p ) ( ρ + r ) v = 0

This establishes point number (1) in Proposition 2.

From the proof of Proposition 1, I know that the solution to this differential equation is of the form

v ( p ) = α 1 p β 1

where β 1 is the positive root of

1 2 σ 2 β 2 + ( r 1 2 σ 2 ) β ( ρ + r ) = 0

Or,

β 2 + ( 2 r σ 2 1 ) β 2 ( ρ + r ) σ 2 = 0

Let λ 1 and λ 2 be the roots of this equation. It follows that

λ 1 + λ 2 = 2 r σ 2 1

λ 1 λ 2 = 2 ( ρ + r ) σ 2

Note that unlike in the proof to Proposition 1, λ 1 ≠ −1.

The positive root is given as

β 1 = ( 2 r σ 2 1 ) + ( 2 r σ 2 1 ) 2 + 8 ( ρ + r ) σ 2 2

It is easy to verify that β 1 > 1.

Using the derivation from the proof of Proposition 1, the threshold for the price of the commodity is

p * = ( β 1 β 1 1 ) K

This establishes point (2) of Proposition 2.

Given p *, it follows that

v ( p ) = ( p p * ) β 1 [ 1 β 1 1 ] N

where

β 1 = ( 2 r σ 2 1 ) + ( 2 r σ 2 1 ) 2 + 8 ( ρ + r ) σ 2 2

Thus, the threshold for the price of the commodity is finite and, since β 1 > 1, the value of the bank note is a convex function of the price of the underlying commodity. This establishes point (3). QED.

A.3 A Sketch of a Proof of Claim 1

With jumps, the price of the commodity is

d p p = μ d t + σ d z δ d q

Let v(p) again denote the value of the bank note. It follows that

d v = v ( p ) [ μ d t + σ d z δ d q ] + 1 2 v ( p ) σ 2 p 2 d t + { v [ ( 1 δ ) p ] v ( p ) } d q

Or,

d v v = μ v d t + σ v d z + 1 v { v [ ( 1 δ ) p ] v ( p ) } d q

Suppose that a bank constructs the following portfolio:

W = p n c + B n n v ( p )

It follows that dW is

d W = [ n c μ p + r B n n μ v v ] d t + [ n c σ p + n n σ v v ] d z + [ n n { v [ ( 1 δ ) p ] v ( p ) } n c δ p ] d q

Suppose that as in Proposition 1 that the bank chooses its reserve ratio such that

n c p n n v = σ v σ

It follows that

d W = [ n n ( σ v v μ σ μ v v ) + r B ] d t + n n [ { v [ ( 1 δ ) p ] v ( p ) } σ v δ v σ ] d q

The risk from the “jump” that is due to discoveries of the commodity cannot be eliminated. I say that this is a sketch of a proof because this does not prove that the risk cannot be perfectly hedged. As mentioned in the text, some argue that jumps should be treated as idiosyncratic risk that can be diversified away.

A.4 Proof of Result 1

Suppose that the bank note is valued as though it has an expected rate of return equal to the risk-free rate. It follows that

E d v v = r d t

Using Ito’s Lemma, this implies that

1 2 σ 2 p 2 v ( p ) + μ p v ( p ) + λ { v [ ( 1 δ ) p ] v ( p ) } = r v ( p )

Or,

1 2 σ 2 p 2 v ( p ) + μ p v ( p ) ( r + λ ) v ( p ) + λ v [ ( 1 δ ) p ] = 0

Let’s conjecture that

v ( p ) = Γ p γ

Plugging this into the differential equation above yields:

1 2 σ 2 γ 2 + ( μ 1 2 σ 2 ) γ ( r + λ ) + λ ( 1 δ ) γ = 0

A positive solution for γ can be obtained via numerical methods. Given that the conjectured solution is a solution, it follows from the proof to Proposition 1 that the value of the bank note can be written as

v ( p ) = ( p p * ) γ [ p * K ] N K

and

p * = ( γ γ 1 ) K

QED.

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Received: 2020-02-10
Accepted: 2021-02-24
Published Online: 2021-04-02

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