Taylor, Stephen J. and Tzeng, Chi-Feng and Widdicks, Martin (2014) Bankruptcy probabilities inferred from option prices. Journal of Derivatives, 22 (2). pp. 8-31. ISSN 1074-1240
Abstract
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.