Capital Structure Effects on the Prices of Individual Equity Call Options

52 Pages Posted: 18 Sep 2014 Last revised: 22 Jul 2015

See all articles by Robert L. Geske

Robert L. Geske

University of California, Los Angeles (UCLA) - Finance Area

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Yi Zhou

San Francisco State University

Date Written: December 3, 2014

Abstract

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

Geske, Robert L. and Subrahmanyam, Avanidhar and Zhou, Yi, Capital Structure Effects on the Prices of Individual Equity Call Options (December 3, 2014). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2497267 or http://dx.doi.org/10.2139/ssrn.2497267

Robert L. Geske

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States

Avanidhar Subrahmanyam (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Yi Zhou

San Francisco State University ( email )

College of Business
1600 Holloway Avenue
San Francisco, CA 94132
United States
(415) 338-2661 (Phone)
(415) 338-0596 (Fax)

HOME PAGE: http://https://cob.sfsu.edu/directory/yi-zhou

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