Capital Structure Effects on the Prices of Individual Equity Call Options
52 Pages Posted: 18 Sep 2014 Last revised: 22 Jul 2015
Date Written: December 3, 2014
We examine whether values of equity options traded on individual firms are sensitive to the firm's capital structure. Specifically, we estimate the compound option (CO) model, which views equity as an option on the firm. Compared to the Black-Scholes (BS) model, the CO model reduces pricing errors by 20% on average, and pricing improvements monotonically increase up to 70% with both leverage and expiration. We show that the CO model implies a market value of firm leverage and allows imputation of the firm's implied volatility, both of which have potential applications in corporate finance.
Keywords: option pricing, leverage effect, compound option
JEL Classification: G12, G13, G32
Suggested Citation: Suggested Citation