Default Option and the Cross-Section of Stock Returns

50 Pages Posted: 18 Sep 2015

See all articles by Assaf Eisdorfer

Assaf Eisdorfer

University of Connecticut - Department of Finance

Amit Goyal

University of Lausanne; Swiss Finance Institute

Alexei Zhdanov

Pennsylvania State University

Date Written: September 16, 2015

Abstract

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

Eisdorfer, Assaf and Goyal, Amit and Zhdanov, Alexei, Default Option and the Cross-Section of Stock Returns (September 16, 2015). Available at SSRN: https://ssrn.com/abstract=2661419 or http://dx.doi.org/10.2139/ssrn.2661419

Assaf Eisdorfer (Contact Author)

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States

Amit Goyal

University of Lausanne ( email )

Quartier Chambronne
Lausanne, Vaud CH-1015
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Alexei Zhdanov

Pennsylvania State University ( email )

University Park
State College, PA 16802
United States

HOME PAGE: http://www.alexeizhdanov.com

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