Equity Option Implied Probability of Default and Equity Recovery Rate
Journal of Futures Markets, Vol. 37, No. 6, 2017
20 Pages Posted: 5 Dec 2015 Last revised: 26 Aug 2019
Date Written: March 25, 2016
There is a close link between prices of equity options and the probability of default of a firm. We show that in the presence of positive expected equity recovery, the standard methods that assume zero equity recovery at default misestimate the probability of default implicit in option prices. We introduce a simple method to detect stocks with positive expected equity recovery by examining option prices, and propose a method to extract the probability of default from option prices in the presence of positive expected equity recovery. Our empirical results based on six large financial institutions in the US during the 2007-2009 crisis show that assuming zero recovery leads to significant mispricing of options and misestimation of implied probability of default.
Keywords: option, default, probability of default, arbitrage bounds
JEL Classification: G01, G12, G13, G14
Suggested Citation: Suggested Citation