The Impact of Credit Risk on Equity Options
80 Pages Posted: 7 Feb 2020
Date Written: January 21, 2020
The aim of this work is to understand and measure to what extent equity options price credit risk. With a novel structural model, the the price of an option is shown to depends on the probability of the option expiring in-the-money, conditional on the firm’s survival. The novelty of this approach stems from the works of Geske (1977) and Geske (1979) where equity is seen as a compound call option written on the firm’s assets. A new measure of impact of credit risk on options is also introduced, and it is shown that put options, contrary to calls, are sensitive to changes in the default risk in the underlying company. In addition, this measure is able to forecast future changes of the negative skew of long-term maturity options written on the equity of the same company. Finally, I show that the implied volatilities estimated á la Black-Scholes tend to average out the effect of credit risk over the moneyness space, leading to potential biases when applied for risk management purposes.
Keywords: Defaultable options, credit risk, leverage effect, volatility skew, market integration
JEL Classification: C63, G12, G13, G32, G33
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