Assessing the Impact of Credit Risk on Equity Options via Information Contents and Compound Options

Federico Maglione and Maria Elvira Mancino
Additional contact information
Federico Maglione: Department of Economics and Management, University of Florence, Via delle Pandette, 9, 50127 Florence, Italy

Risks, 2023, vol. 11, issue 10, 1-25

Abstract: This work aims to develop a measure of how much credit risk is priced into equity options. Such a measure appears particularly appealing when applied to a portfolio of equity options, as it allows for the factoring in of firm-specific default dynamics, thus producing a comparable statistic across different equities. As a matter of fact, comparing options written on different equities based on their moneyness does offer much guidance in understanding which option offers a better hedging against default. Our newly-introduced measure aims to fulfil this gap: it allows us to rank options written on different names based on the amount of default risk they carry, incorporating firm-specific characteristics such as leverage and asset risk. After having computed this measure using data from the US market, several empirical tests confirm the economic intuition of puts being more sensitive to changes in the default risk as well as a good integration of the CDS and option markets. We further document cross-sectional sectorial differences based on the industry the companies operate in. Moreover, we show that this newly-introduced measure displays forecasting power in explaining future changes in the skew of long-term maturity options.

Keywords: defaultable options; credit risk; leverage effect; volatility skew (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.mdpi.com/2227-9091/11/10/183/pdf (application/pdf)
https://www.mdpi.com/2227-9091/11/10/183/ (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:gam:jrisks:v:11:y:2023:i:10:p:183-:d:1264236

Access Statistics for this article

Risks is currently edited by Mr. Claude Zhang

More articles in Risks from MDPI
Bibliographic data for series maintained by MDPI Indexing Manager ().