Discussion Paper Series 2012-E-14

A Framework for Extracting the Probability of Default from Stock Option Prices

Azusa Takeyama, Nick Constantinou, Dmitri Vinogradov

This paper develops a framework to estimate the probability of default (PD) implied in listed stock options. The underlying option pricing model measures PD as the intensity of a jump diffusion process, in which the underlying stock price jumps to zero at default. We adopt a two-stage calibration algorithm to obtain the precise estimator of PD. In the calibration procedure, we improve the fitness of the option pricing model via the implementation of the time inhomogeneous term structure model in the option pricing model. Since the term structure model perfectly fits the actual term structure, we resolve the estimation bias caused by the poor fitness of the time homogeneous term structure model. It is demonstrated that the PD estimator from listed stock options can provide meaningful insights on the pricing of credit derivatives like credit default swap.

Keywords: probability of default (PD); option pricing under credit risk; perturbation method

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2012 Bank of Japan All Rights Reserved.

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