Default Risk and Option Returns

This paper studies the effects of default risk on equity option returns. We show that there is a cross-sectional and a time-series relation between default risk and 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 where the negative relation between option returns and default risk is driven by firm leverage and asset volatility