Review of Quantitative Finance and Accounting, 16, 131–148, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Determinants of the Dollar Value of Default Risk:
A Put Option Perspective
QUENTIN C. CHU
Area of Finance, The Fogelman College of Business and Economics, The University of Memphis, Memphis,
TN 38152 Fax: (901) 678-2685
Department of Banking and Finance, TamKang University, Tamsui, Taipei County 25137, Taiwan
Abstract. This study uses the option valuation framework to identify and investigate the factors affecting the
cross-sectional differences in individual corporate bonds’ default risk. The dollar value of default risk (DVDR) is
measured by subtracting the observed trading price of a risky corporate bond from a Cox-Ingersoll-Ross model
value of a corresponding pseudo-default-free bond. From an option pricing perspective, DVDR can be modeled as
the value of a put option on the ﬁrm’s risky assets. The DVDR of an individual investment-grade corporate bond
is hypothesized to be related to the bond rating, time to maturity of the bond, size of the issuing ﬁrm, volatility
of ﬁrm value, and dividend yield of the issuing ﬁrm. In the case of the ﬁrst four factors, the empirical results are
consistent with the predictions from a put option perspective. There is a mixed relationship between DVDR and
dividend yield, however, which provides a weaker support for the prediction of the option valuation model. Such a
mixed relationship documents the important role that dividend payments play in signaling a ﬁrm’s future earnings
and reducing overall agency costs. [“In particular, the formula can be used to derive the discount that should be
applied to a corporate bond because of the possibility of default.” (Black and Scholes (1973), Journal of Political
Economy, Abstract, p. 637.)]
Key words: dollar value of default risk, put option, bond rating, bond pricing, corporate bond
JEL Classiﬁcation: C21, G13, G32
The 1997 Nobel Prize Economics Committee cites as one of the major contributions of
Black, Merton, and Scholes the laying of a foundation for a uniﬁed theory to price all
In a simpliﬁed corporate setting with nondividend-paying stock and
risky zero-coupon bonds, stock can be evaluated as a call option on the ﬁrm’s risky assets.
The dollar value of default risk (DVDR), deﬁned as the price difference between the risky
corporate bond and a corresponding pseudo-default-free bond, can be modeled as a put
option on the issuing ﬁrm’s risky assets.
Correspondence to: Professor Quentin C. Chu.