Implied Default Probabilities and Recovery Rates from Option Prices
56 Pages Posted: 19 Mar 2011 Last revised: 30 Oct 2017
Date Written: September 27, 2017
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: Suggested Citation