Default Risk and Option Returns

61 Pages Posted: 1 Oct 2015 Last revised: 20 May 2019

See all articles by Aurelio Vasquez

Aurelio Vasquez

Instituto Tecnológico Autónomo de México (ITAM) - Department of Business Administration

Xiao Xiao

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Erasmus Research Institute of Management (ERIM)

Date Written: May 15, 2019

Abstract

This paper studies the effects of default risk on equity option returns. Under a stylized capital structure model, expected delta-hedged equity option returns have a negative relation with default risk, driven by firm leverage and asset volatility. Empirically, we find that delta-hedged equity option returns monotonically decrease with higher default risk measured by credit ratings or default probability. We also find that default risk drives the predictability of existing anomalies in the equity option market. For all ten anomalies, the long-short option returns are higher for high default risk firms.

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

JEL Classification: C14, G13, G17

Suggested Citation

Vasquez, Aurelio and Xiao, Xiao, Default Risk and Option Returns (May 15, 2019). Available at SSRN: https://ssrn.com/abstract=2667930 or http://dx.doi.org/10.2139/ssrn.2667930

Aurelio Vasquez (Contact Author)

Instituto Tecnológico Autónomo de México (ITAM) - Department of Business Administration ( email )

Rio Hondo No. 1
Col. Tizapan-San Angel, 01000
Mexico

Xiao Xiao

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

Erasmus Research Institute of Management (ERIM) ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

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