Pricing credit risk through equity options calibration: Part 2 – model implementation

Purpose – To implement the model described in the companion paper, “Pricing credit risk through equity options calibration, part 1 – theory,” and show how to calculate the price of a set of coupon bonds issued by a US telecommunications and media company, AOL Time Warner, based on the information retrieved by the AOL equity derivatives market. Design/methodology/approach – The risk-neutral density function of AOL Time Warner's stock is inferred from options volatilities; from there, the AOL assets risk neutral density function is calculated together with the default probabilities at different dates in the future. Finally, a set of AOL coupon bonds are priced accordingly and compared to market prices. Findings – The AOL model-theoretical prices are close to market prices, meaning that it is possible to perform relative-value analysis in the risky bonds market based on the equity markets information. Originality/value – The paper shows how easily the model can be used as a tool for performing relative-value analysis between the equity options and the credit markets by using real market data.