Equity-implied Methods and Risk-neutrality Transformations

Jorge A Chan-Lau

Chapter 4 covered methods for assessing the probability of default of a single institution using the prices of credit default swaps and bonds. There are several reasons why these instruments are useful for assessing default risk, especially credit derivatives. Market participants consider the prices of these contracts as clean measures of default risk since their payouts depend on the survival of the firm. Notwithstanding this fact and the rapid growth of the credit derivatives market since the early 2000s, not all firms are referenced in credit default swaps. While bond spreads could substitute for credit default swaps, secondary trading volume in corporate bond markets is low, given the large participation of buy-and-hold institutional investors.

Within this environment, the information in equity prices offers an alternative mean of gauging the solvency of a firm. Compared with credit derivatives and the bond markets, equity markets are deep and liquid, offering two-way prices for the shares of a large number of firms. The option-like nature of equity and the availability of balance-sheet data allow for the use of option-pricing techniques for estimating the default probability