Default Option and the Cross-Section of Stock Returns
50 Pages Posted: 18 Sep 2015
Date Written: September 16, 2015
We argue that default option is important for equity valuation and construct a model that explicitly prices the option to default or abandon the firm. An investment strategy that buys stocks that are classified as undervalued by our model and shorts overvalued stocks generates an annual 4-factor alpha of about 11% for U.S. stocks. The model’s performance is stronger for stocks with higher value of default option, such as distressed or highly volatile stocks. We construct a similar strategy in a sample of nine most highly capitalized developed markets and find consistent results. Our findings suggest that investors do not properly incorporate the value of default options in stock prices.
Keywords: Asset pricing, Default option
JEL Classification: G12, G13, G33
Suggested Citation: Suggested Citation