The Impact of Credit Risk on Equity Options

80 Pages Posted: 7 Feb 2020 Last revised: 13 Oct 2020

Date Written: January 21, 2020

Abstract

The aim of this work is to understand and measure to what extent equity options price credit risk. With the exception of Toft and Prucyk (1997), which is a dated work based on the simplistic assumption of a reference company issuing perpetual debt, all the work in the literature which try to establish a link between the credit default swaps and equity options rely on reduced-form models (Carr and Linetsky 2006, Carr and Wu 2010, Carr et al. 2010). Thus, the connection between the firm's fundamentals and the pricing of these derivative contracts are ignored. With a novel structural model, which stems from Geske (1977, 1979), equity is priced as a compound call option written on the firm's asset. The proposed structural model is first able to reconcile some puzzling findings documented by Carrand Wu (2017) on increasing leverage due to increasing business risk. Moreover, as the price equity options is shown to depends on the probability of the option expiring in-the-money, conditional on the firm's survival, this decomposition allows to construct a new measure of impact of credit risk on options. It is then 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 \'a 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

Suggested Citation

Maglione, Federico, The Impact of Credit Risk on Equity Options (January 21, 2020). Proceedings of Paris December 2020 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3523051 or http://dx.doi.org/10.2139/ssrn.3523051

Federico Maglione (Contact Author)

Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

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