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Equity Misvaluation and Default Options

52 Pages Posted: 29 Oct 2016 Last revised: 3 Nov 2016

Assaf Eisdorfer

University of Connecticut - Department of Finance

Amit Goyal

University of Lausanne; Swiss Finance Institute

Alexei Zhdanov

Pennsylvania State University

Date Written: April 28, 2016

Abstract

We study whether default options are mispriced in equity prices by employing a structural equity valuation model that explicitly takes into account the value of the option to default (or abandon the firm) and uses firm-specific accounting inputs. We implement our model on the entire cross-section of stocks and identify both over- and underpriced equity. 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 find similar results in a sample of nine most highly capitalized developed markets.

Keywords: Mispricing, Default Options, Stock Returns

JEL Classification: G12, G13, G31, G33

Suggested Citation

Eisdorfer, Assaf and Goyal, Amit and Zhdanov, Alexei, Equity Misvaluation and Default Options (April 28, 2016). Available at SSRN: https://ssrn.com/abstract=2860888

Assaf Eisdorfer

University of Connecticut - Department of Finance ( email )

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

Amit Goyal

University of Lausanne ( email )

Lausanne, Vaud CH-1015
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

Alexei Zhdanov (Contact Author)

Pennsylvania State University ( email )

University Park
State College, PA 16802
United States

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

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