A Framework for Extracting the Probability of Default from Stock Option Prices

Azusa Takeyama, Nick Constantinou and Dmitri Vinogradov
Additional contact information
Azusa Takeyama: Deputy Director and Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail: azusa.takeyama@boj.or.jp)
Nick Constantinou: Lectuer, Essex Business School, University of Essex (E-mail: nconst@essex.ac.uk)

No 12-E-14, IMES Discussion Paper Series from Institute for Monetary and Economic Studies, Bank of Japan

Abstract: This paper develops a framework to estimate the probability of default (PD) implied in listed stock options. The underlying option pricing model measures PD as the intensity of a jump diffusion process, in which the underlying stock price jumps to zero at default. We adopt a two-stage calibration algorithm to obtain the precise estimator of PD. In the calibration procedure, we improve the fitness of the option pricing model via the implementation of the time inhomogeneous term structure model in the option pricing model. Since the term structure model perfectly fits the actual term structure, we resolve the estimation bias caused by the poor fitness of the time homogeneous term structure model. It is demonstrated that the PD estimator from listed stock options can provide meaningful insights on the pricing of credit derivatives like credit default swap.

Keywords: probability of default (PD); option pricing under credit risk; perturbation method (search for similar items in EconPapers)
JEL-codes: C12 C53 G13 (search for similar items in EconPapers)
Date: 2012-10
New Economics Papers: this item is included in nep-ban, nep-cmp and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:ime:imedps:12-e-14

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