Default Risk and Option Returns

Abstract

This paper studies the effects of default risk on equity option returns. We show that there is a cross-sectional and a time-series relation between default risk and option returns. In the cross-section, expected delta-hedged equity option returns have a negative relation with default risk measured by credit ratings or default probability. In the time-series, credit rating downgrades (upgrades) lead to a decrease (increase) in the firm's delta-hedged option return. Our results are consistent with a stylized capital structure model where the negative relation between option returns and default risk is driven by firm leverage and asset volatility.

Keywords: Delta-Hedged Option Returns, Default Risk, Variance Risk Premium, Volatility, Capital Structure Model

JEL Classification: C14, G13, G17