A Framework for Extracting the Probability of Default from Listed Stock Option Prices

38 Pages Posted: 25 Nov 2011

See all articles by Azusa Takeyama

Azusa Takeyama

University of Essex

Nick Constantinou

University of Essex - Essex Business School

Dmitri Vinogradov

University of Glasgow - Adam Smith Business School

Date Written: November 14, 2011

Abstract

This paper develops a framework to estimate the probability of default (PD) implied in listed stock options. The underlying option pricing model measures PD as the intensity of the jump diffusion that the underlying stock price becomes zero. We adopt a two stage calibration algorithm to obtain the precise estimator of PD. In the calibration procedure, we improve the fitness of the option pricing model via the implementation of the time inhomogeneous term structure model in the option pricing model. As the term structure model perfectly fits the actual term structure, we resolve the estimation bias caused by the poor fitness of the time homogeneous term structure model. It is demonstrated that the PD estimator from listed stock options can provide meaningful insights on the pricing of credit derivatives like credit default swap.

Keywords: probability of default (PD), option pricing under credit risk, perturbation method

Suggested Citation

Takeyama, Azusa and Constantinou, Nick and Vinogradov, Dmitri, A Framework for Extracting the Probability of Default from Listed Stock Option Prices (November 14, 2011). Available at SSRN: https://ssrn.com/abstract=1964413 or http://dx.doi.org/10.2139/ssrn.1964413

Azusa Takeyama (Contact Author)

University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

Nick Constantinou

University of Essex - Essex Business School ( email )

Wivenhoe Park
Colchester, Essex CO4 3SQ
United Kingdom

Dmitri Vinogradov

University of Glasgow - Adam Smith Business School ( email )

Glasgow, Scotland
United Kingdom

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