Pricing credit risk through equity options calibration: Part 2 – model implementation

Abstract

Purpose

To implement the model described in the companion paper, “Pricing credit risk through equity options calibration, part 1 – theory,” and show how to calculate the price of a set of coupon bonds issued by a US telecommunications and media company, AOL Time Warner, based on the information retrieved by the AOL equity derivatives market.

Design/methodology/approach

The risk‐neutral density function of AOL Time Warner's stock is inferred from options volatilities; from there, the AOL assets risk neutral density function is calculated together with the default probabilities at different dates in the future. Finally, a set of AOL coupon bonds are priced accordingly and compared to market prices.

Findings

The AOL model‐theoretical prices are close to market prices, meaning that it is possible to perform relative‐value analysis in the risky bonds market based on the equity markets information.

Originality/value

The paper shows how easily the model can be used as a tool for performing relative‐value analysis between the equity options and the credit markets by using real market data.

Citation

Fabio Delzio, M. (2006), "Pricing credit risk through equity options calibration: Part 2 – model implementation", Journal of Risk Finance, Vol. 7 No. 4, pp. 386-401. https://doi.org/10.1108/15265940610692626