Default Risk and Option Returns
61 Pages Posted: 1 Oct 2015 Last revised: 20 May 2019
Date Written: May 15, 2019
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
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