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S. Taylor, et al., “Bankruptcy Probabilities Inferred from Option Prices,” (Lancaster University, 23 August 2012).

S. Taylor, et al., “Bankruptcy Probabilities Inferred from Option Prices,” (Lancaster University, 23 August 2012).

Abstract: Option prices contain forward looking information about stock price volatility and, potentially, the probability of bankruptcy. We develop a risk-neutral density (RND) model consisting of a mixture of two lognormal densities with a probability of bankruptcy. We calibrate this model to daily stock and option prices of six financial institutions during the onset of the financial crisis to see what information about bankruptcy probabilities can be inferred from option prices. The bankruptcy probability and the shape of the RND for the institutions are examined, particularly on major event dates. The empirical results show that acquiring banks have a lower bankruptcy probability than the acquired banks; RNDs of financial institutions reflect market shocks, especially in fat tails and bankruptcy probability. The results from multivariate regressions for each institution suggest that the small volatile firms, with low returns, have a higher chance of bankruptcy than large stable firms with high returns.