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Using equity options to imply credit information

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  • Angie Elkhodiry
  • Joseph Paradi
  • Luis Seco

Abstract

The evolution of credit derivatives has inspired many researchers to investigate the behaviour of credit spreads. Today the growing consensus is that the equity option market provides sufficient information to estimate latent credit parameters. Hull et al. (J. Credit Risk 1(1):3–28, 2005 ) propose a clever approach to estimate credit spreads from the equity option market. In this paper we first perform a time series analysis to test the conjecture of an existing relationship between credit spreads and implied equity volatility and find strong evidence of a positive relationship. We also propose an extension to Hull et al.’s paper that significantly improves credit spread estimation. Copyright Springer Science+Business Media, LLC 2011

Suggested Citation

  • Angie Elkhodiry & Joseph Paradi & Luis Seco, 2011. "Using equity options to imply credit information," Annals of Operations Research, Springer, vol. 185(1), pages 45-73, May.
    • Handle: RePEc:spr:annopr:v:185:y:2011:i:1:p:45-73:10.1007/s10479-009-0627-z
    DOI: 10.1007/s10479-009-0627-z
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    References listed on IDEAS

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    1. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. "Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-1632, December.
    2. Leland, Hayne E & Toft, Klaus Bjerre, 1996. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    3. Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(4), pages 541-552, November.
    4. Lara Cathcart & Lina El-Jahel, 2006. "Pricing defaultable bonds: a middle-way approach between structural and reduced-form models," Quantitative Finance, Taylor & Francis Journals, vol. 6(3), pages 243-253.
    5. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-367, May.
    6. Chen, Cho-Jieh & Panjer, Harry, 2003. "Unifying discrete structural models and reduced-form models in credit risk using a jump-diffusion process," Insurance: Mathematics and Economics, Elsevier, vol. 33(2), pages 357-380, October.
    7. Joseph P. Ogden, 1987. "Determinants Of The Ratings And Yields On Corporate Bonds: Tests Of The Contingent Claims Model," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 10(4), pages 329-340, December.
    8. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2789-2811, November.
    9. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409, World Scientific Publishing Co. Pte. Ltd..
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    11. Geske, Robert, 1979. "The valuation of compound options," Journal of Financial Economics, Elsevier, vol. 7(1), pages 63-81, March.
    12. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
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    Cited by:

    1. Hideharu Funahashi & Tomohide Higuchi, 2018. "An analytical approximation for single barrier options under stochastic volatility models," Annals of Operations Research, Springer, vol. 266(1), pages 129-157, July.
    2. Tarik Driouchi & Lenos Trigeorgis & Raymond H. Y. So, 2018. "Option implied ambiguity and its information content: Evidence from the subprime crisis," Annals of Operations Research, Springer, vol. 262(2), pages 463-491, March.
    3. Rongda Chen & Liu Yang & Weijin Wang & Ling Tang, 2015. "Discovering the impact of systemic and idiosyncratic risk factors on credit spread of corporate bond within the framework of intelligent knowledge management," Annals of Operations Research, Springer, vol. 234(1), pages 3-15, November.

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