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1 – 2 of 2To 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…
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.
Details
Keywords
To propose a new methodology to infer the risk‐neutral default probability curve of a generic firm XYZ from equity options prices.
Abstract
Purpose
To propose a new methodology to infer the risk‐neutral default probability curve of a generic firm XYZ from equity options prices.
Design/methodology/approach
It is assumed that the market is arbitrage‐free and the “market” probability measure implied in the equity options prices to the pricing of credit risky assets is applied. First, the equity probability density function of XYZ is inferred from a set of quoted equity options with different strikes and maturities. This function is then transformed into the probability density function of the XYZ assets and the term structure of the “option implied” XYZ default probabilities is calculated. These default probabilities can be used to price corporate bonds and, more generally, single‐name credit derivatives as “exotic” equity derivatives.
Findings
Equity derivatives and credit derivatives have ultimately the same (unobservable) underlying, the XYZ assets value. A model that considers any security issued by XYZ as derivatives on the firm's assets can be used to price these securities in a consistent way to each other and/or detect relative/value opportunities.
Originality/value
The paper offers both a pricing tool for traded single‐name credit risky assets or a relative value tool in liquid markets.
Details