Equity Misvaluation and Default Options
62 Pages Posted: 29 Oct 2016 Last revised: 3 Feb 2018
Date Written: January 1, 2018
We study whether default options are mispriced in equity values 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 inputs. We implement our model on the entire cross-section of stocks and identify both over- and underpriced equities. An investment strategy that buys undervalued stocks 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.
Keywords: Mispricing, Default Options, Stock Returns
JEL Classification: G12, G13, G31, G33
Suggested Citation: Suggested Citation