Option-Based Bankruptcy Prediction
University of Cyprus
University of Cyprus - Department of Public and Business Administration; Columbia University - Columbia Business School
EFMA 2000 Athens
This study builds on option-pricing theory to explain business bankruptcy based on a sample of 139 matched pairs of bankrupt and control U.S. firms for the period 1983-94. Our results indicate that the primary option-motivated variables, such as firm volatility, play an important role in predicting default, one, two and three years prior to bankruptcy. When the model is extended to account for the probability of default on interest payments due at intermediate times prior to debt maturity (either due to voluntary equityholder default or due to cash flow problems), related profitability and cash-flow/liquidity variables are shown to have incremental predictive power, while the primary option variables remain statistically significant. Our theory-driven model has significant explanatory power and prediction ability in all years tested.
Number of Pages in PDF File: 27
Keywords: Option pricing, bankruptcy
Date posted: February 12, 2001