Accepted author manuscript, 1.4 MB, PDF document
Research output: Contribution to Journal/Magazine › Journal article › peer-review
Research output: Contribution to Journal/Magazine › Journal article › peer-review
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TY - JOUR
T1 - Bankruptcy probabilities inferred from option prices
AU - Taylor, Stephen J.
AU - Tzeng, Chi-Feng
AU - Widdicks, Martin
N1 - Accepted by journal editor 2014.
PY - 2014
Y1 - 2014
N2 - Option prices contain forward looking information about stock price volatility and, potentially, the probability of default. We develop a risk-neutral density (RND) model consisting of a mixture of two lognormal densities augmented with a probability of bankruptcy. To test the model we calibrate it to daily stock and option prices of six financial institutions during the onset of the 2008 financial crisis. We find that the addition of the probability of bankruptcy term substantially improves the quality of the fit of the RND. The bankruptcy probability and the shape of the RND for the institutions are examined, particularly on major event dates. We show that acquiring banks have lower bankruptcy probabilities than the acquired banks and that the RNDs of financial institutions reflect market shocks, especially through the implied bankruptcy probabilities.
AB - Option prices contain forward looking information about stock price volatility and, potentially, the probability of default. We develop a risk-neutral density (RND) model consisting of a mixture of two lognormal densities augmented with a probability of bankruptcy. To test the model we calibrate it to daily stock and option prices of six financial institutions during the onset of the 2008 financial crisis. We find that the addition of the probability of bankruptcy term substantially improves the quality of the fit of the RND. The bankruptcy probability and the shape of the RND for the institutions are examined, particularly on major event dates. We show that acquiring banks have lower bankruptcy probabilities than the acquired banks and that the RNDs of financial institutions reflect market shocks, especially through the implied bankruptcy probabilities.
KW - Option prices
KW - Bankruptcy probability
KW - Risk-neutral density
KW - Financial crisis
U2 - 10.3905/jod.2014.22.2.008
DO - 10.3905/jod.2014.22.2.008
M3 - Journal article
VL - 22
SP - 8
EP - 31
JO - Journal of Derivatives
JF - Journal of Derivatives
SN - 1074-1240
IS - 2
ER -