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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

In this paper, we present a novel method to extract the risk-neutral probability of default of a firm from American put option prices. Building on the idea of a default corridor proposed in Carr and Wu (2011), we derive a parsimonious closed-form formula for American put option prices from which the probability of default can be inferred. The proposed method is easy to implement and helps overcome the main limitation of the method used in Carr and Wu (2011), which relies on the price of one deep-out-of-the-money put option. Our empirical results are based on seven large U.S. firms for the period 2002 to 2010. These results show that, in some cases, the option-implied probability of default can provide a more accurate estimate of default probability, compared to the estimates implied from credit default swap spreads.

Suggested Citation

  • Bo Young Chang & Greg Orosi, 2020. "A Simple Method for Extracting the Probability of Default from American Put Option Prices," Staff Working Papers 20-15, Bank of Canada.
    • Handle: RePEc:bca:bocawp:20-15
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    References listed on IDEAS

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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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    More about this item

    Keywords

    Asset Pricing; Financial markets; Market structure and pricing;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G3 - Financial Economics - - Corporate Finance and Governance
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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