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Default Risk and Option Returns

Aurelio Vasquez () and Xiao Xiao ()
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Aurelio Vasquez: Instituto Tecnologico Autonomo de Mexico, 01080 Mexico City, Mexico
Xiao Xiao: Bayes Business School, City University of London, London EC1Y 8TZ, United Kingdom

Management Science, 2024, vol. 70, issue 4, 2144-2167

Abstract: This paper studies the effects of default risk on expected equity option returns. In the cross-section, expected delta-hedged equity option returns have a negative relation with default risk measured by credit ratings or default probability. In the time series, credit rating downgrades (upgrades) lead to a decrease (increase) in the firm’s delta-hedged option return. Our results are consistent with a stylized capital structure model in which the negative relation between option returns and default risk is driven by firm leverage and asset volatility.

Keywords: delta-hedged option returns; default risk; variance risk premium; volatility; capital structure model (search for similar items in EconPapers)
Date: 2024
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http://dx.doi.org/10.1287/mnsc.2023.4796 (application/pdf)

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