Using Contingent-Claims Analysis to Value Opportunities Lost Due to Moral Hazard Risk

Abstract

Long-term contracts may contain valuable embedded options. I develop an alternative approach to traditional discounted cash flow (DCF) analysis for valuing the profits that are lost when a long-term contract is breached, resulting in the loss of potentially valuable options. One recent example concerns the much publicized supervisory goodwill contracts, some of which were scheduled to expire more than 30 years from the time the US government breached them. I illustrate the contingent-claims approach using this example. I develop a contingent-claims damages model and use it to measure the lost profits damages that two thrifts - California Federal Bank and Glendale Federal Bank - suffered when the US government extinguished supervisory goodwill and prematurely terminated their long-dated goodwill options. The same analytical approach can be adapted to value other opportunities lost due to moral hazard risk.

Keywords: traftional discounted cash flow, DCF, long-term contract, goodwill contracts, contingent claims damages model, California Federal Bank, Glendale Federal Bank