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A Simple Method for Extracting the Probability of Default from American Put Option Prices

Bo Young Chang and Greg Orosi

Staff Working Papers from Bank of Canada

Abstract: In this paper, we present a novel method to extract the risk-neutral probability of default of a firm from American put option prices. Building on the idea of a default corridor proposed in Carr and Wu (2011), we derive a parsimonious closed-form formula for American put option prices from which the probability of default can be inferred. The proposed method is easy to implement and helps overcome the main limitation of the method used in Carr and Wu (2011), which relies on the price of one deep-out-of-the-money put option. Our empirical results are based on seven large U.S. firms for the period 2002 to 2010. These results show that, in some cases, the option-implied probability of default can provide a more accurate estimate of default probability, compared to the estimates implied from credit default swap spreads.

Keywords: Asset Pricing; Financial markets; Market structure and pricing (search for similar items in EconPapers)
JEL-codes: G1 G13 G3 G33 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2020-04
New Economics Papers: this item is included in nep-cfn and nep-rmg
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