Title: A robust method to retrieve option implied risk neutral densities for defaultable assets

Authors: Guillaume Leduc; Greg Orosi

Addresses: American University of Sharjah, P.O. Box 26666, Sharjah, UAE ' American University of Sharjah, P.O. Box 26666, Sharjah, UAE

Abstract: Risk neutral densities recovered from option prices can be used to infer market participants' expectations of future stock returns and are a vital tool for pricing illiquid exotic options. Although there is a broad literature on the subject, most studies do not address the likelihood of default. To fill this gap, in this paper we develop a novel method to retrieve the risk neutral probability density function from call options written on a defaultable asset. The primary advantage of the method is that default probabilities inferred by the model can be analytically expressed and, if available, can be incorporated as an input in a flexible, robust and easily implementable manner.

Keywords: risk neutral densities; default probability; call options; bankruptcy; defaultable assets; option prices.

DOI: 10.1504/IJFMD.2016.081704

International Journal of Financial Markets and Derivatives, 2016 Vol.5 No.2/3/4, pp.212 - 224

Received: 10 Sep 2016
Accepted: 26 Oct 2016
Published online: 20 Jan 2017 *

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