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Emerging Market Bank Valuation: A Call Option Model

A bank is a call option on a portfolio of assets. A bank’s assets primarily consist of government debt, loans, and a smattering of equity. In India, this optionality got a bit ahead of itself through 2014. In spite of the persistent sell-off we have seen since early this year, India bank equity—Axis Bank, Baroda, State Bank of India, ICICI bank, Hindu development bank—is still rich. The trend shows a move to fair value.

Here’s the Story. Indian equity—and especially banks—had a huge run in the latter part of 2013 to present. The factors driving this were interest rate easing, the reform-minded Modi altering policy settings, and finally the drop in oil prices acted as a boost to the economy as India is very dependent on energy imports. Behind these factors is a favorable combination of growing population and rising incomes. For these reasons, I watch them closely.

Here’s the reality. A model that reflects the aforementioned optionality using the 10Y local currency government bonds and corporate debt yields has decent fitness, and it shows that bank equity was seriously overvalued around January 2015. Since then the trend has been mean reverting, but Indian banks stocks still in overvalued territory.

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