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Capital structure effects on the prices of equity call options

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  • Geske, Robert
  • Subrahmanyam, Avanidhar
  • Zhou, Yi

Abstract

We examine whether values of equity options traded on individual firms are sensitive to the firm’s capital structure. We estimate the compound option (CO) model, which views equity as an option on the firm. Compared with the Black-Scholes model, the CO model with a term structure of volatility (TSV) reduces pricing errors by 20% on average. The compound option effect is particularly strong for highly levered firms and long-term options, in which the pricing improvement is up to 70% of the Black-Scholes error. Without a TSV, the CO model reduces pricing errors of in-the-money options by 12.74% on average and for out-of-the-money by 9.22%. We show that the CO model implies a market value of firm leverage and allows imputation of the firm’s implied volatility, both of which have potential applications in corporate finance.

Suggested Citation

  • 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.
    • Handle: RePEc:eee:jfinec:v:121:y:2016:i:2:p:231-253
    DOI: 10.1016/j.jfineco.2016.03.009
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    Cited by:

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    2. Bai, Jennie & Goldstein, Robert S. & Yang, Fan, 2019. "The leverage effect and the basket-index put spread," Journal of Financial Economics, Elsevier, vol. 131(1), pages 186-205.
    3. Michael B. Imerman, 0. "When enough is not enough: bank capital and the Too-Big-To-Fail subsidy," Review of Quantitative Finance and Accounting, Springer, vol. 0, pages 1-36.
    4. Alex Backwell & Thomas A. McWalter & Peter H. Ritchken, 2022. "On buybacks, dilutions, dividends, and the pricing of stock‐based claims," Mathematical Finance, Wiley Blackwell, vol. 32(1), pages 273-308, January.
    5. Chen, Ding & Guo, Biao & Zhou, Guofu, 2023. "Firm fundamentals and the cross-section of implied volatility shapes," Journal of Financial Markets, Elsevier, vol. 63(C).
    6. Robert F. Engle & Emil N. Siriwardane, 2018. "Structural GARCH: The Volatility-Leverage Connection," Review of Financial Studies, Society for Financial Studies, vol. 31(2), pages 449-492.
    7. A. W. Rathgeber & J. Stadler & S. Stöckl, 2021. "The impact of the leverage effect on the implied volatility smile: evidence for the German option market," Review of Derivatives Research, Springer, vol. 24(2), pages 95-133, July.
    8. Michael B. Imerman, 2020. "When enough is not enough: bank capital and the Too-Big-To-Fail subsidy," Review of Quantitative Finance and Accounting, Springer, vol. 55(4), pages 1371-1406, November.
    9. Borochin, Paul & Wu, Zekun & Zhao, Yanhui, 2021. "The effect of option-implied skewness on delta- and vega-hedged option returns," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 74(C).
    10. Sobhesh Kumar Agarwalla & Sumit Saurav & Jayanth R. Varma, 2022. "Lottery and bubble stocks and the cross‐section of option‐implied tail risks," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(2), pages 231-249, February.
    11. Abdullah, Hariem & Tursoy, Turgut, 2021. "Capital structure and firm performance: a panel causality test," MPRA Paper 105871, University Library of Munich, Germany.
    12. Kwangil Bae, 2019. "Valuation and applications of compound basket options," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 39(6), pages 704-720, June.

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    More about this item

    Keywords

    Derivatives; Options; Leverage; Stochastic volatility;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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