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Pricing credit risk through equity options calibration Part 1 – theory

Pricing credit risk through equity options calibration Part 1 – theory Purpose – To propose a new methodology to infer the risk‐neutral default probability curve of a generic firm XYZ from equity options prices. Design/methodology/approach – It is assumed that the market is arbitrage‐free and the “market” probability measure implied in the equity options prices to the pricing of credit risky assets is applied. First, the equity probability density function of XYZ is inferred from a set of quoted equity options with different strikes and maturities. This function is then transformed into the probability density function of the XYZ assets and the term structure of the “option implied” XYZ default probabilities is calculated. These default probabilities can be used to price corporate bonds and, more generally, single‐name credit derivatives as “exotic” equity derivatives. Findings – Equity derivatives and credit derivatives have ultimately the same (unobservable) underlying, the XYZ assets value. A model that considers any security issued by XYZ as derivatives on the firm's assets can be used to price these securities in a consistent way to each other and/or detect relative/value opportunities. Originality/value – The paper offers both a pricing tool for traded single‐name credit risky assets or a relative value tool in liquid markets. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Risk Finance Emerald Publishing

Pricing credit risk through equity options calibration Part 1 – theory

The Journal of Risk Finance , Volume 7 (4): 14 – Aug 1, 2006

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Publisher
Emerald Publishing
Copyright
Copyright © 2006 Emerald Group Publishing Limited. All rights reserved.
ISSN
1526-5943
DOI
10.1108/15265940610688955
Publisher site
See Article on Publisher Site

Abstract

Purpose – To propose a new methodology to infer the risk‐neutral default probability curve of a generic firm XYZ from equity options prices. Design/methodology/approach – It is assumed that the market is arbitrage‐free and the “market” probability measure implied in the equity options prices to the pricing of credit risky assets is applied. First, the equity probability density function of XYZ is inferred from a set of quoted equity options with different strikes and maturities. This function is then transformed into the probability density function of the XYZ assets and the term structure of the “option implied” XYZ default probabilities is calculated. These default probabilities can be used to price corporate bonds and, more generally, single‐name credit derivatives as “exotic” equity derivatives. Findings – Equity derivatives and credit derivatives have ultimately the same (unobservable) underlying, the XYZ assets value. A model that considers any security issued by XYZ as derivatives on the firm's assets can be used to price these securities in a consistent way to each other and/or detect relative/value opportunities. Originality/value – The paper offers both a pricing tool for traded single‐name credit risky assets or a relative value tool in liquid markets.

Journal

The Journal of Risk FinanceEmerald Publishing

Published: Aug 1, 2006

Keywords: Credit; Equity capital; Risk analysis; Bonds; Financial modelling

References

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