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Options on Leveraged Equity: Theory and Empirical Tests

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  • Toft, Klaus Bjerre
  • Prucyk, Brian

Abstract

The authors develop an option pricing model for calls and puts written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The model explains implied Black-Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and debt covenants. The authors test the model by comparing predicted pricing biases with biases observed in a large cross-section of firms with liquid exchange traded option contracts. Their empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by their model. The authors also find significant pricing biases for firms financed primarily by short-term debt. This supports their model because short-term debt introduces net-worth hurdles similar to net-worth covenants. Copyright 1997 by American Finance Association.

Suggested Citation

  • Toft, Klaus Bjerre & Prucyk, Brian, 1997. " Options on Leveraged Equity: Theory and Empirical Tests," Journal of Finance, American Finance Association, vol. 52(3), pages 1151-1180, July.
  • Handle: RePEc:bla:jfinan:v:52:y:1997:i:3:p:1151-80
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    Cited by:

    1. Cremers, Martijn & Driessen, Joost & Maenhout, Pascal & Weinbaum, David, 2008. "Individual stock-option prices and credit spreads," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2706-2715, December.
    2. Marco Realdon, "undated". "Valuation of Put Options on Leveraged Equity," Discussion Papers 03/19, Department of Economics, University of York.
    3. Mjøs, Aksel & Persson, Svein-Arne, 2010. "A simple model of deferred callability in defaultable debt," European Journal of Operational Research, Elsevier, vol. 207(3), pages 1350-1357, December.
    4. Pascal Barneto, 2003. "La scission d'Eridania-Béghin-Say:essai d'évaluation par un modèle d'options réelles," Revue Finance Contrôle Stratégie, revues.org, vol. 6(2), pages 5-42, June.
    5. Shibata, Takashi & Tian, Yuan, 2012. "Debt reorganization strategies with complete verification under information asymmetry," International Review of Economics & Finance, Elsevier, vol. 22(1), pages 141-160.
    6. Brown, Christine A. & Wang, Sally, 2002. "Credit risk: The case of First Interstate Bankcorp," International Review of Financial Analysis, Elsevier, vol. 11(2), pages 229-248.
    7. Vedolin, Andrea, 2012. "Uncertainty and leveraged Lucas Trees: the cross section of equilibrium volatility risk premia," LSE Research Online Documents on Economics 43091, London School of Economics and Political Science, LSE Library.
    8. Xu, Ruxing & Li, Shenghong, 2010. "Belief updating, debt pricing and financial decisions under asymmetric information," Research in International Business and Finance, Elsevier, vol. 24(2), pages 123-137, June.
    9. Pierre Collin-Dufresne & Robert S. Goldstein & Fan Yang, 2010. "On the Relative Pricing of long Maturity S&P 500 Index Options and CDX Tranches," NBER Working Papers 15734, National Bureau of Economic Research, Inc.
    10. Mjøs, Aksel & Persson, Svein-Arne, 2010. "Callable risky perpetual debt with protection period," European Journal of Operational Research, Elsevier, vol. 207(1), pages 391-400, November.
    11. Jan Ericsson & Joel Reneby, 2003. "Stock options as barrier contingent claims," Applied Mathematical Finance, Taylor & Francis Journals, vol. 10(2), pages 121-147.
    12. Yan, Shu, 2011. "Jump risk, stock returns, and slope of implied volatility smile," Journal of Financial Economics, Elsevier, vol. 99(1), pages 216-233, January.
    13. Core, John E. & Schrand, Catherine M., 1999. "The effect of accounting-based debt covenants on equity valuation1," Journal of Accounting and Economics, Elsevier, vol. 27(1), pages 1-34, February.
    14. Nan Chen & S. G. Kou, 2009. "Credit Spreads, Optimal Capital Structure, And Implied Volatility With Endogenous Default And Jump Risk," Mathematical Finance, Wiley Blackwell, vol. 19(3), pages 343-378.
    15. Hanke, Michael & Potzelberger, Klaus, 2002. "Consistent pricing of warrants and traded options," Review of Financial Economics, Elsevier, vol. 11(1), pages 63-77.
    16. Geske, Robert & Subrahmanyam, Avanidhar & Zhou, Yi, 2016. "Capital structure effects on the prices of equity call options," Journal of Financial Economics, Elsevier, vol. 121(2), pages 231-253.
    17. Bakshi, Gurdip & Madan, Dilip & Panayotov, George, 2010. "Returns of claims on the upside and the viability of U-shaped pricing kernels," Journal of Financial Economics, Elsevier, vol. 97(1), pages 130-154, July.
    18. Ben Ammar, Semir, 2016. "Pricing of Catastrophe Risk and the Implied Volatility Smile," Working Papers on Finance 1617, University of St. Gallen, School of Finance.
    19. Bandi, Chaithanya & Bertsimas, Dimitris, 2014. "Robust option pricing," European Journal of Operational Research, Elsevier, vol. 239(3), pages 842-853.
    20. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    21. Câmara, António & Popova, Ivilina & Simkins, Betty, 2012. "A comparative study of the probability of default for global financial firms," Journal of Banking & Finance, Elsevier, vol. 36(3), pages 717-732.
    22. Feng, Shu & Zhang, Yi & Friesen, Geoffrey C., 2015. "The relationship between the option-implied volatility smile, stock returns and heterogeneous beliefs," International Review of Financial Analysis, Elsevier, vol. 41(C), pages 62-73.

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