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Rice research explains a new way to measure default risk for investors

Equity options can act as an alternative to credit default swaps for detecting a company’s credit risk. Photo via Getty Images

Up until the 2007-2009 financial crisis, credit default swaps (CDS) were a predominant method for predicting the probability of corporate default. CDS function like insurance for loan assets — if an asset defaults, the bank who purchased the CDS would recoup their loss. Higher-risk assets usually have higher premiums, and in this way the price of a CDS indicates the probability of default.

When the housing market crashed in 2007, the CDS market crashed along with it when banks had to pay out more than they had expected. The CDS market is not expected to ever return to its previous high, leaving a void in market-driven estimates for determining an asset’s default probability.

To fill that void, a team of researchers including Rice Business Professor Robert Dittmar created an alternative method for measuring default risk: equity options data. The team found that equity options not only correlate with CDS data in terms of accurate prediction of default but also provide additional insights on what types of assets are more likely to default, and when they will default.

There are two types of options, a call option, which is essentially a bet that a stock’s price will be higher than a contracted value (the strike price) and a put option, which is a bet that a stock’s price will be less than a contracted value.

A put is often viewed as an insurance contract — if you hold a stock, but also a put option on it, you limit your loss on the stock if the stock price falls.

“What we are looking at is essentially how expensive put options get,” says Dittmar. “If the market thinks a company is likely to default, it expects that its stock value will fall (almost to zero). As a result, put options, which represent insurance against this loss become more expensive. We are looking at how these option prices change to see if they inform us about the probabilities of default.”

According to Dittmar and his team, this approach has several advantages. 1) There are more stocks with options than CDS. 2) The CDS market is drying up whereas the option market remains liquid. And 3) Because of the nature of an option contract, and the fact that in principle equity holders have the lowest claim on a company’s assets, this approach may allow investors to predict losses in case of default.

The team looked at CDS quotes on 276 firms between 2002 and 2017, focusing attention on entities that had quote data available on one-year credit default swaps. The 15-year sample enabled the researchers to analyze the money lost through defaults over a longer period of time, including the 2007-2009 financial crisis.

Using equity options data as a predictor of default led to some interesting insights. First, there are two components that investors in corporate bonds think about when weighing default risk — the probability of default and (should there be a default) how much of the bond’s principal they will get back (i.e., recovery rate). “What we see is that credit ratings imply different levels of default thresholds, which may mean that investors believe that there are differences in the amount that debt holders will lose in the case of default,” says Dittmar.

Second, option-implied default probabilities correlate to historical changes in the economy. Default probabilities are higher in bad economic times and for firms with poorer credit ratings and financial positions. Default spikes are more likely during times of economic turbulence, such as the financial crisis of 2007-2009, which correlated with the decline of the CDS market after an onslaught of debt defaults during the recession. Assets are less likely to default during times of economic expansion. Over the period of 2013-2017, forecasted losses through defaults hovered around 15%.

The research sample ends in 2017, and the paper was published in 2020, about a month after the start of the coronavirus pandemic. Since then, there have been unprecedented changes in the economy, and some economists are anticipating another recession in 2023. With such instability in the market, multiple methods of predicting losses should be especially relevant. This research suggests that the equity options market may provide additional ways of finding the probability of these losses.

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This article originally ran on Rice Business Wisdom and was based on research from Robert Dittmar, professor of finance at the Jones Graduate School of Business at Rice University.

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Baylor College of Medicine's Lillie and Roy Cullen Tower is set to open in 2026. Rendering courtesy of BCM

Baylor College of Medicine has collected $100 million toward its $150 million fundraising goal for the college’s planned Lillie and Roy Cullen Tower.

The $100 million in gifts include:

  • A total of $30 million from The Cullen Foundation, The Cullen Trust for Health Care, and The Cullen Trust for Higher Education.
  • $12 million from the DeBakey Medical Foundation
  • $10 million from the Huffington Foundation
  • More than $45 million from members of Baylor’s Board of Trustees and other community donors, including the M.D. Anderson Foundation, the Albert and Margaret Alkek Foundation, and The Elkins Foundation.

“The Cullen Trust for Health Care is very honored to support this building along with The Cullen Foundation and The Cullen Trust for Higher Education,” Cullen Geiselman Muse, chair of The Cullen Trust for Health Care, says in a news release. “We cannot wait to see what new beginnings will come from inside the Lillie and Roy Cullen Tower.”

The Baylor campus is next to Texas Medical Center’s Helix Park, a 37-acre project. Rendering courtesy of BCM

The Lillie and Roy Cullen Tower is set to open in 2026. The 503,000-square-foot tower is the first phase of Baylor’s planned Health Sciences Park, an 800,000-square-foot project that will feature medical education and research adjacent to patient care at Baylor Medicine and Baylor St. Luke’s Medical Center on the McNair Campus.

The Baylor campus is next to Texas Medical Center’s Helix Park, a 37-acre project that will support healthcare, life sciences, and business ventures. Baylor is the anchor tenant in the first building being constructed at Helix Park.

“To really change the future of health, we need a space that facilitates the future,” says Dr. Paul Klotman, president, CEO, and executive dean of Baylor. “We need to have a great building to recruit great talent. Having a place where our clinical programs are located, where our data scientists are, next to a biotech development center, and having our medical students all integrated into that environment will allow them to be ready in the future for where healthcare is going.”

In the 1940s, Lillie and Roy Cullen and the M.D. Anderson Foundation were instrumental in establishing the Texas Medical Center, which is now the world’s largest medical complex.

“Baylor is the place it is today because of philanthropy,” Klotman says. “The Cullen family, the M.D. Anderson Foundation, and the Albert and Margaret Alkek Foundation have been some of Baylor’s most devoted champions, which has enabled Baylor to mold generations of exceptional health sciences professionals. It is fitting that history is repeating itself with support for this state-of-the-art education building.”

The Cullen Foundation donated $30 million to the project. Rendering courtesy of BCM

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