Equity Option Implied Probability of Default and Equity Recovery Rate

Journal of Futures Markets, Vol. 37, No. 6, 2017

20 Pages Posted: 5 Dec 2015 Last revised: 26 Aug 2019

See all articles by Bo Young Chang

Bo Young Chang

Bank of Canada

Greg Orosi

American University of Sharjah

Date Written: March 25, 2016

Abstract

There is a close link between prices of equity options and the probability of default of a firm. We show that in the presence of positive expected equity recovery, the standard methods that assume zero equity recovery at default misestimate the probability of default implicit in option prices. We introduce a simple method to detect stocks with positive expected equity recovery by examining option prices, and propose a method to extract the probability of default from option prices in the presence of positive expected equity recovery. Our empirical results based on six large financial institutions in the US during the 2007-2009 crisis show that assuming zero recovery leads to significant mispricing of options and misestimation of implied probability of default.

Keywords: option, default, probability of default, arbitrage bounds

JEL Classification: G01, G12, G13, G14

Suggested Citation

Chang, Bo Young and Orosi, Greg, Equity Option Implied Probability of Default and Equity Recovery Rate (March 25, 2016). Journal of Futures Markets, Vol. 37, No. 6, 2017. Available at SSRN: https://ssrn.com/abstract=2698831 or http://dx.doi.org/10.2139/ssrn.2698831

Bo Young Chang

Bank of Canada ( email )

234 Wellington St.
Ottawa, Ontario K1A0G9
Canada
613-782-8936 (Phone)
613-782-7136 (Fax)

HOME PAGE: http://www.bankofcanada.ca/author/bo-young-chang-2/

Greg Orosi (Contact Author)

American University of Sharjah ( email )

Sharjah
United Arab Emirates

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