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.

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• Keyword(s):
• equity markets 41
• finance 247

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