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A simple method for extracting the probability of default from American put option prices

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  • Bo Young Chang
  • Greg Orosi

Abstract

We present a novel method for extracting the risk‐neutral probability of default (PD) of a firm from American put option prices. Building on the idea of a default corridor proposed by Carr and Wu, we derive a parsimonious closed‐form formula for American put option prices from which the PD can be inferred. The method is easy to implement. Our empirical results based on seven large US firms for the period 2002–2010 show that, in some cases, our option‐implied PD can provide a more accurate estimate of default probability than the estimates implied from credit default swaps.

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  • 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.
    • Handle: RePEc:wly:jfutmk:v:40:y:2020:i:10:p:1535-1547
    DOI: 10.1002/fut.22146
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    1. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    2. 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.
    3. Peter Carr & Liuren Wu, 2011. "A Simple Robust Link Between American Puts and Credit Protection," Review of Financial Studies, Society for Financial Studies, vol. 24(2), pages 473-505.
    4. Peter Carr & Liuren Wu, 2010. "Stock Options and Credit Default Swaps: A Joint Framework for Valuation and Estimation," Journal of Financial Econometrics, Oxford University Press, vol. 8(4), pages 409-449, Fall.
    5. Doshi, Hitesh & Elkamhi, Redouane & Ornthanalai, Chayawat, 2018. "The Term Structure of Expected Recovery Rates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 53(6), pages 2619-2661, December.
    6. 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.
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    Cited by:

    1. 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.

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