A Framework for Extracting the Probability of Default from Stock Option Prices
AbstractThis paper develops a framework to estimate the probability of default (PD) implied in listed stock options. The underlying option pricing model measures PD as the intensity of a jump diffusion process, in which the underlying stock price jumps to zero at default. We adopt a two-stage calibration algorithm to obtain the precise estimator of PD. In the calibration procedure, we improve the fitness of the option pricing model via the implementation of the time inhomogeneous term structure model in the option pricing model. Since the term structure model perfectly fits the actual term structure, we resolve the estimation bias caused by the poor fitness of the time homogeneous term structure model. It is demonstrated that the PD estimator from listed stock options can provide meaningful insights on the pricing of credit derivatives like credit default swap.
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Bibliographic InfoPaper provided by Institute for Monetary and Economic Studies, Bank of Japan in its series IMES Discussion Paper Series with number 12-E-14.
Date of creation: Oct 2012
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probability of default (PD); option pricing under credit risk; perturbation method;
Find related papers by JEL classification:
- C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-10-27 (All new papers)
- NEP-BAN-2012-10-27 (Banking)
- NEP-CMP-2012-10-27 (Computational Economics)
- NEP-RMG-2012-10-27 (Risk Management)
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