Abstract

In the first of three essays, I introduce a new method for measuring and analyzing cross sectional leverage and credit effects on option prices of individual firms. I use Merton's (1973) model of stock as an option on firm value, Geske's (1979) compound option model to value an option on the stock as an option on an option on firm value and Modigiliani and Miller, which allows me to compute the market value of the debt on a daily basis from three contemporaneous market prices: option price, stock price and strike price. I compare Geske's leverage model to the models of Black Scholes (BS, 1973), Bakshi, Cao, and Chen (BCC, 1997) and Pan (2002). I demonstrate that leverage has significant statistical and economic cross sectional effects on the prices of individual stock options by reducing the pricing errors by 60% on average. The improvement is monotonic both in leverage and in time to option expiration.

In the second essay, we introduce the first method for measuring and analyzing market leverage and credit risk effects on asset prices in the economy. We present the first market debt to equity (D/E) ratio derived from option theory using only contemporaneous market price data for the index level and index option prices. We demonstrate that this time series variation in the market value of aggregate corporate leverage of these 500 companies has significant economic effects on the prices of index put option on the S&P 500. We show that by including leverage as a variable, Geske's option model is superior to models which omit leverage, BS (1973) and BCC (1997).

In the third essay, we examine whether existing market leverage has a significant statistical and economic effect on the pricing of S&P 500 index call options. We demonstrate that this time series variation in the market value of aggregate corporate leverage of these 500 companies has significant economic effects on the prices of index call option on the S&P 500. We show that by including leverage as a variable, Geske's option model is superior to models which omit leverage, BS (1973) and BCC (1997).