PRICING DEFAULT RISK WITH PARISIAN OPTIONS: EMPIRICAL EVIDENCE FROM HIGH GROWTH COMPANIES

In the stock market crash of 2000 many internet firms that were ostensibly bankrupt were able to stave off bankruptcy by seeking protection under Chapter 11 or avoid it completely through refinancing or merging with another company. The implication is that these firms had a de facto option to choose when to default and that this option had substantial value. This paper builds on this insight and investigates how the value of a company is affected by the default option and the choice of the relevant bankruptcy procedures. We use a Parisian barrier option framework and extend Schwartz and Moon's (2000) contingent claim model, which implies only a Chapter 7 bankruptcy procedure, to allow for the more general bankruptcy procedure of Chapter 11. We consider bankruptcy procedures that are explicitly based on the time spent in financial distress and include a "grace" period in the model to more realistically capture the effects of default risk on firm value. Finally, we develop an efficient Monte Carlo method to price approximations for the Parisian options. Some numerical results and comparative statics are also performed to demonstrate the characteristics of cumulative and consecutive Parisian options and investigate their effects on the value of high growth firms.