Default risk and option returns

In the paper Default Risk and Option Returns, the authors study the effects of default risk on expected equity option returns. It shows that there is a cross-sectional and a time-series relation between default risk and expected option returns. In the cross-section, expected delta-hedged equity option returns have a negative relation with default risk measured by credit ratings or default probability. In the time-series, credit rating downgrades (upgrades) lead to a decrease (increase) in the firm’s delta-hedged option return.

The results are consistent with a stylised capital structure model where the negative relation between option returns and default risk is driven by firm leverage and asset volatility.

The accepted version of Default Risk and Option Returns is available to download at City Research Online. It is published in Management Science.