Equity Option-Implied Probability of Default and Equity Recovery Rate

Bo Young Chang and Greg Orosi

Staff Working Papers from Bank of Canada

Abstract: There is a close link between prices of equity options and the default probability of a firm. We show that in the presence of positive expected equity recovery, standard methods that assume zero equity recovery at default misestimate the option-implied default probability. We introduce a simple method to detect stocks with positive expected equity recovery by examining option prices and propose a method to extract the default probability from option prices that allows for positive equity recovery. We demonstrate possible applications of our methodology with examples that include large financial institutions in the United States during the 2007–09 subprime crisis.

Keywords: Asset Pricing; Financial markets; Market structure and pricing (search for similar items in EconPapers)
JEL-codes: G13 G33 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2016
New Economics Papers: this item is included in nep-cfn and nep-rmg
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:16-58

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