Default Risk and Option Returns

Abstract

This paper studies the effects of default risk on expected equity option returns. In the cross-section, expected delta-hedged equity option returns have a negative relation with default risk measured by credit ratings or default probability. In the time series, credit rating downgrades (upgrades) lead to a decrease (increase) in the firm’s delta-hedged option return. Our results are consistent with a stylized capital structure model in which the negative relation between option returns and default risk is driven by firm leverage and asset volatility. This paper was accepted by Lukas Schmid, finance. Funding: A. Vasquez thanks the Asociación Mexicana de Cultura A.C. for financial support. Supplemental Material: The online appendix and data are available at https://doi.org/10.1287/mnsc.2023.4796 .