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Implied Default Probabilities and Recovery Rates from Option Prices

56 Pages Posted: 19 Mar 2011 Last revised: 30 Oct 2017

Jennifer S. Conrad

University of North Carolina Kenan-Flagler Business School

Robert F. Dittmar

University of Michigan, Stephen M. Ross School of Business

Allaudeen Hameed

National University of Singapore (NUS) - Department of Finance

Date Written: September 27, 2017

Abstract

We propose a novel method of estimating default probabilities using equity option data. The resulting default probabilities are highly correlated with estimates of default probabilities extracted from CDS spreads, which assume constant recovery rates. Additionally, the option implied default probabilities are higher in bad economic times and for firms with poorer credit ratings and financial positions. An inferred recovery rate, after controlling for liquidity effects, is also related to underlying business and firm conditions, varies across sectors and predicts subsequent equity returns.

Keywords: CDS, options,default probabilities, recovery

JEL Classification: C13, C14, G12, G13, G20

Suggested Citation

Conrad, Jennifer S. and Dittmar, Robert F. and Hameed, Allaudeen, Implied Default Probabilities and Recovery Rates from Option Prices (September 27, 2017). AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1786977 or http://dx.doi.org/10.2139/ssrn.1786977

Jennifer S. Conrad (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Robert F. Dittmar

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Allaudeen Hameed

National University of Singapore (NUS) - Department of Finance ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore

HOME PAGE: http://www.bschool.nus.edu.sg/staff_profile/cv.asp?ID=3

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