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Equity Option Implied Probability of Default and Equity Recovery Rate

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  • Bo Young Chang
  • Greg Orosi

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 financial institutions in the United States during the 2007–09 subprime crisis. © 2016 Wiley Periodicals, Inc. Jrl Fut Mark 37:599–613, 2017

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  • Bo Young Chang & Greg Orosi, 2017. "Equity Option Implied Probability of Default and Equity Recovery Rate," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 37(6), pages 599-613, June.
    • Handle: RePEc:wly:jfutmk:v:37:y:2017:i:6:p:599-613
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    Cited by:

    1. Florent Kanga GBONGUE & Lambert N’Galadjo BAMBA, 2023. "Le modèle hybride de la structure par terme des primes souveraines de crédit et de liquidité dans la zone UEMOA," Region et Developpement, Region et Developpement, LEAD, Universite du Sud - Toulon Var, vol. 57, pages 101-145.
    2. Bo Young Chang & Greg Orosi, 2020. "A Simple Method for Extracting the Probability of Default from American Put Option Prices," Staff Working Papers 20-15, Bank of Canada.
    3. Jean‐François Bégin & Mathieu Boudreault & Mathieu Thériault, 2024. "Leveraging prices from credit and equity option markets for portfolio risk management," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 44(1), pages 122-147, January.
    4. Bo Young Chang & Greg Orosi, 2020. "A simple method for extracting the probability of default from American put option prices," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(10), pages 1535-1547, October.

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