Spring 2012 Prof.

Tarek Eldomiaty 1
Part 3

The Use of Options Pricing for
Estimating Distance to Default
(DD) and Probability of Default
(PD)
Spring 2012 Prof.Tarek Eldomiaty 2
Default Risk
Default risk is the uncertainty surrounding a firms
ability to service its debts and obligations.
Firms pay a spread over the default-risk free rate of
interest that is proportional to their default probability
to compensate the lenders for this uncertainty.
Spring 2012 Prof.Tarek Eldomiaty 3
Options Pricing
Myron S. Scholes, 1941
Fisher Black
Spring 2012 Prof.Tarek Eldomiaty 4
Options Pricing
} { } { ) (
2 1
d N Xe d SN t C
rt
=
The expected stock
price at time period
t
The expected present value of
the exercise (buying) price
at time period t
Spring 2012 Prof.Tarek Eldomiaty 5
http://www.moodys.com/
Spring 2012 Prof.Tarek Eldomiaty 6
Call Options and Distance to Default
The holder of a call option on the assets has a
claim on the assets after meeting the strike price
of the option.
The strike price = book value of liabilities.
The merge between Option pricing and bankruptcy
ensures that if the value of the assets is
insufficient to meet the liabilities of the firm, then
the shareholders (holders of the call option), will
not exercise their option and will leave the firm to
its creditors.
Spring 2012 Prof.Tarek Eldomiaty 7
Call Options and Distance to Default
} { } {
2 1
d N Xe d N V V
rt
A E

=
The expected Firm Value at time
period t
The expected present value of firm
liabilities at time period t
Spring 2012 Prof.Tarek Eldomiaty 8
} { } {
2 1
d N e X d N V V
rt
A E

=
The implied market
value of the
firms assets
The book value of
debt
} {
} {
1
2
d N
d N e X V
V
rt
E
A

+
=
Implied Market Value of Firms Assets
Spring 2012 Prof.Tarek Eldomiaty 9
} {
} {
1
2
d N
d N e X V
V
rt
E
A

+
=
= the value of the Standard Normal Cumulative Distribution
= NORMSDIST, or NORMDIST (x,0,1)
( ) d N
= market value of equity
E
V
= Book value of debt

X
= time horizon
= risk-free rate of return = minimum rate the firm is to achieve

t
r
Implied Market Value of Firms Assets
Spring 2012 Prof.Tarek Eldomiaty 10
Call Options and Distance to Default
( )
( )
t d
t
t r
X
V
d
t
t r
X
V
d
A
A
A
A
A
o
o
o
o
o
=
+
|
.
|

\
|
=
+ +
|
.
|

\
|
=
1
2
2
2
1

5 . 0 ln
5 . 0 ln
= Value of firms assets = market value of equity + total debt

= Observed volatility of firms assets

A
V
2
A
o
Distance to default (DD)
Spring 2012 Prof.Tarek Eldomiaty 11
Call Options and Distance to Default
( )
( )
t d
t
t r
X
V
d
t
t r
X
V
d
A
A
A
A
A
o
o
o
o
o
=
+
|
.
|

\
|
=
+ +
|
.
|

\
|
=
1
2
2
2
1

5 . 0 ln
5 . 0 ln
Distance to Default (DD): The number of standard deviations the
future value of assets is away from the default point
Higher values indicate a borrower further from default.

Distance to default (DD)
Spring 2012 Prof.Tarek Eldomiaty 12
How to Calculate the Observed Volatility
of Firms Assets?
= Observed volatility of firms assets. It can be obtained from
the relationship between equity and asset volatility that follows.

2
A
o
A
E E
A
V
V o
o =
= market value of equity

= Observed volatility of firms equity =
E
V
E
o
MV % A
o
Spring 2012 Prof.Tarek Eldomiaty 13
Call Options and Distance to Default:
Exercise
Market Capitalization (billion) 3
Equity Volatility (per annum) 40%
Total Liabilities (billion) 10
= 3

= 40%

= 10

= 3 + 10 = 13
E
V
E
o
X
A
V
Spring 2012 14
Prof.Tarek Eldomiaty
Call Options and Distance to Default
( )
( )
3.3378 1 09231 . 0 4301 . 3
3.3378
1 09231 . 0
1 00852 . 0 5 . 0 % 5
10
13
ln
3.4301
1 09231 . 0
1 00852 . 0 5 . 0 % 5
10
13
ln
2
1
= =
=

+
|
.
|

\
|
=
=

+ +
|
.
|

\
|
=
d
d
= 13
= 10
=1 = one year

A
V
X
t
% 231 . 9
13
% 40 3
=

= =
A
E E
A
V
V o
o
Spring 2012 15
Prof.Tarek Eldomiaty
} 3378 . 3 {
} 4301 . 3 {
N
N
The values for the Standard Normal Cumulative Distribution can
be either obtained from the statistical tables or the Excel
= NORMSDIST, or = NORMDIST (x,0,1)
0.9996 } 1 , 0 , 3378 . 3 {
0.9997 } 1 , 0 , 4301 . 3 {
=
=
N
N
Implied Market Value of Firms Assets
Spring 2012 16
Prof.Tarek Eldomiaty
Spring 2012 17
Prof.Tarek Eldomiaty
( )
12.5121
0.9997
0.9996 71828 . 2 10 3
} {
} {
1 % 5
1
2
=
+
=
+
=

A
rt
E
A
V
d N
d N e X V
V
Implied Market Value of Firms Assets
The implied market value of the firms assets calculates as follows
Spring 2012 18
Prof.Tarek Eldomiaty
The implied market value of the firms assets is used for
calculating the implied asset volatility as follows.
9.6%
12.5121
% 40 3
=

= =
A
E E
A
V
V o
o
What is the relationship between the observed and the
implied asset volatility?
Implied Asset Volatility
Spring 2012 19
Prof.Tarek Eldomiaty
Probability of Default (PD)
The Probability of Default can be obtained either from the
statistical tables or the Excel
Using tables, The PD = 1- Standard Normal Cumulative
Distribution.
PD = 1- N{d2}

Using Excel, the PD = NORMSDIST (-d2) ,
= NORMDIST (-d2 ,0 ,1)

0.00042 0.9996 - 1 } 3378 . 3 { 1 = = = N DP
The PD = 0.00042 basis points = 0.042% risk premium
Spring 2012 Prof.Tarek Eldomiaty 20
Distance to default and Financial Ratios
Spring 2012 Prof.Tarek Eldomiaty 21
Spring 2012 Prof.Tarek Eldomiaty 22
Spring 2012 Prof.Tarek Eldomiaty 23