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A. Vasquez, X. Xiao – “Default Risk and Option Returns”

A. Vasquez, X. Xiao – “Default Risk and Option Returns”

This paper studies the effects of default risk on equity option returns. We examine the cross section of delta-hedged equity option returns for Optionmetrics stock for the period January 1996 to April 2016. We find that options on stocks with high default risk  earn significantly lower returns than options on low default risk stocks. The high minus low return spreads for quintile and decile option portfolios sorted by credit rating or default probability range from -1.14% to -1.54%, with t-statistics ranging from -9.84 to -5.17. Our empirical results are supported theoretically by a stylized capital structure model, which models equity as an option on the firm. Under this model, delta-hedged equity option returns also have a negative relation with default risk. We provide evidence that this negative relation is driven by firm leverage, asset volatility, and debt maturity. Finally, we find that the profitability of existing option anomalies is larger for firms with high default risk and, for some anomalies, is confined to these firms.