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Default Risk and Option Returns

Author

Listed:
  • Aurelio Vasquez

    (Instituto Tecnologico Autonomo de Mexico, 01080 Mexico City, Mexico)

  • Xiao Xiao

    (Bayes Business School, City University of London, London EC1Y 8TZ, United Kingdom)

Abstract

This paper studies the effects of default risk on expected equity option returns. In the cross-section, expected delta-hedged equity option returns have a negative relation with default risk measured by credit ratings or default probability. In the time series, credit rating downgrades (upgrades) lead to a decrease (increase) in the firm’s delta-hedged option return. Our results are consistent with a stylized capital structure model in which the negative relation between option returns and default risk is driven by firm leverage and asset volatility.

Suggested Citation

  • Aurelio Vasquez & Xiao Xiao, 2024. "Default Risk and Option Returns," Management Science, INFORMS, vol. 70(4), pages 2144-2167, April.
    • Handle: RePEc:inm:ormnsc:v:70:y:2024:i:4:p:2144-2167
    DOI: 10.1287/mnsc.2023.4796
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