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Market-Based Solutions to Vital Economic Issues
Research
Sep 27, 2017

Cross-Market and Cross-firm Effects in Implied Default Probabilities and Recovery Values

Abstract

We propose a novel method of estimating default probabilities using equity option data. The resulting default probabilities are highly correlated with estimates of default probabilities extracted from CDS spreads, which assume constant recovery rates. Additionally, the option implied default probabilities are higher in bad economic times and for firms with poorer credit ratings and financial positions. An inferred recovery rate, after controlling for liquidity effects, is also related to underlying business and firm conditions, varies across sectors and predicts subsequent equity returns.

Note: Research papers posted on SSRN, including any findings, may differ from the final version chosen for publication in academic journals.

 


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