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The Option-iPoD: The Probability of Default Implied by Option Prices Based on Entropy

31 Pages Posted: 12 Sep 2008  

Christian Capuano

Swiss Financial Market Supervisory Authority (FINMA)

Date Written: August 2008

Abstract

We present a framework to derive the probability of default implied by the price of equity options. The framework does not require any strong statistical assumption, and provide results that are informative on the expected developments of balance sheet variables, such as assets, equity and leverage, and on the Greek letters (delta, gamma and vega). We show how to extend the framework by using information from the price of a zero-coupon bond and CDS-spreads. In the episode of the collapse of Bear Stearns, option-iPoD was able to early signal market sentiment.

Keywords: Credit, Bond markets, Risk management, Financial risk, Financial institutions

Suggested Citation

Capuano, Christian, The Option-iPoD: The Probability of Default Implied by Option Prices Based on Entropy (August 2008). IMF Working Papers, Vol. , pp. 1-29, 2008. Available at SSRN: https://ssrn.com/abstract=1266527

Christian Capuano (Contact Author)

Swiss Financial Market Supervisory Authority (FINMA) ( email )

Einsteinstrasse 2
Bern, 3003
Switzerland

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