A Framework for Extracting the Probability of Default from Stock Option Prices

Takeyama, A., Constantinou, N. and Vinogradov, D. (2011) A Framework for Extracting the Probability of Default from Stock Option Prices. Working Paper. Essex Finance Centre.

Abstract

This paper develops a framework to estimate the probability of default (PD) implied in listed stock options. The underlying option pricing model measures PD as the intensity of a jump diffusion process, in which the underlying stock price jumps to zero at default. We adopt a two-stage calibration algorithm to obtain the precise estimator of PD. In the calibration procedure, we improve the fitness of the option pricing model via the implementation of the time inhomogeneous term structure model in the option pricing model. Since the term structure model perfectly fits the actual term structure, we resolve the estimation bias caused by the poor fitness of the time homogeneous term structure model. It is demonstrated that the PD estimator from listed stock options can provide meaningful insights on the pricing of credit derivatives like credit default swap.

• Item Type: Research Reports or Papers (Working Paper)
• Status: Published
• Glasgow Author(s) Enlighten ID: Vinogradov, Professor Dmitri
• Authors: Takeyama, A., Constantinou, N., and Vinogradov, D.
• College/School: College of Social Sciences > Adam Smith Business School > Accounting and Finance
• Publisher: Essex Finance Centre