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An Analysis of the Implied Probability of Bankruptcy for Chapter

11 Firms and Global Banks Impacted by the Subprime Crisis

Abstract

This article presents a modiﬁcation of Merton’s (1976) ruin option pricing model to estimate the

implied probability of bankruptcy from stock and option market prices. Our model is important to

the literature on measuring bankruptcy and default probabilities because it yields daily estimates

of bankruptcy risk. To test our model, we analyze the impact of the subprime mortgage crisis on

global banking institutions and other ﬁrms over the period January 2007 to May 2008. We ﬁnd a

dramatic increase in the probability of bankruptcy for these groups. For example, the bankruptcy

probability for Bear Stearns reaches 30 percent on March 12, 2008; Fannie Mae’s probability reaches

46% on March 18, 2008; and the probability for UBS is 35 percent on March 20, 2008. We also

estimate the model for 109 large ﬁrms that ﬁled Chapter 11 bankruptcy over the period 1998-2006.

The mean delta for the Chapter 11 ﬁling group is 24.5 percent versus 1.9 percent for S&P 500 ﬁrms.

Furthermore, our bankruptcy estimates are on average consistent with z-scores, debt ratings, and

equity ratings, but we are able to anticipate increases of speciﬁc bankruptcy probabilities in cases

where ratings remain unchanged.

1

Electronic copy available at: http://ssrn.com/abstract=773844

1 Introduction

Corporate bankruptcy is central to the theory of the ﬁrm. As pointed out by Jensen and

Meckling (1976) “the legal deﬁnition of bankruptcy is diﬃcult to specify precisely. In general,

it occurs when the ﬁrm cannot meet a current payment on a debt obligation...In this event the

stockholders have lost all claims on the ﬁrm, and the remaining loss, the diﬀerence between the

face value of the ﬁxed claims and the market value of the ﬁrm, is borne by the debtholders”. This is

the deﬁnition of bankruptcy that we adopt in this paper. Probability of bankruptcy is the likelihood

that stockholders will walk away with nothing and the stock will lose all its value.

This paper aims to achieve several goals by presenting both theory and empirical evidence

on a contemporaneous method for estimating the implied probability of bankruptcy. We present

a modiﬁcation of the Merton’s (1976) ruin model and derive closed-form solutions for the price

of options written on individual stocks. Our option pricing equations depend on the probability

of bankruptcy, the volatility of the stock, and the other observables that aﬀect the Black-Scholes

model. Since bankruptcy probability is not an observable variable, calls and puts can be inverted to

yield simultaneously the implied probability of bankruptcy and the implied volatility as functions

of the stock price, the stock option price, and other observables.

We empirically test our model on two crucial samples. First, we examine all major ﬁrms that

ﬁled for Chapter 11 bankruptcy protection in which options were traded over the period 1998-2006.

The model predicts well for this group: the mean implied bankruptcy probability for Chapter 11

ﬁrms is 24.5 percent versus 1.9 percent for Standard and Poors 500 ﬁrms. The diﬀerence in means

of the bankruptcy probabilities is signiﬁcant at the one percent level. Our results are robust across

industries and years of the sample period. Furthermore, the implied probability of bankruptcy

is generally consistent with z-scores, senior long-term debt ratings, and common stock ratings for

sample ﬁrms.

Second, we test our model on ﬁrms impacted by the subprime crisis. The subprime crisis,

2

which began in the U.S., has had profound eﬀects globally. Our analysis of this crisis provides

new evidence on the ﬁnancial interlinkages for bankruptcy risk of global banking institutions and

nonﬁnancial ﬁrms. Speciﬁcally, we analyze the universe of all ﬁnancial ﬁrms and selected building

construction and credit services ﬁrms with traded stock options, and the results are striking. We

ﬁnd that the average probability of bankruptcy for the whole ﬁnancial ﬁrms universe increases from

1 percent to 7 percent while the default probability for the building construction ﬁrms increases

from 1 to 15 percent. A few noteworthy examples are as follows: the bankruptcy probability for

Bear Stearns reaches 30 percent on March 12, 2008; Fannie Mae’s bankruptcy probability reaches 46

percent on March 18, 2008; and Countrywide Financial’s bankruptcy probability hits 84.5 percent

on November 20, 2007, less than two months before they were rescued through acquisition by Bank

of America. Our results illustrate the two types of channels for international transmission of the

subprime crisis: common shocks (a concurrent impact such as experienced by money center banks

globally) and spillover eﬀects (a delayed impact, which our results show as of May 2008 is still

unfolding for regional banks both in the U.S. and globally). The spillover eﬀect can be observed

for Banco Bradesco (Brasil) with default probability of 52.82% computed on May 27, 2008. It

could also be noted that for 15 out of 23 credit services ﬁrms, the maximum value of the default

probability is achieved after March 2008 and at the end of May 2008 there is still a noticeable

upward trend in the average default probability for that group.

Our bankruptcy risk is the ex-ante subjective bankruptcy probability embedded by the market

about the likelihood that shareholders will lose all their investment in the stock during the life of

the option. Recent ﬁnancial scandals (e.g. Enron) reported by the ﬁnancial press suggest that for

some ﬁrms this ex-ante probability might be diﬀerent from zero and worth considering by an option

pricing model. For example, according to a ﬁling with the SEC in June 2003, the communications

provider Genuity reports that the ﬁrm “believes that its stockholders will not receive any proceeds

from the liquidation and that its common stock will have no value in connection with the liquida-

3

tion”. In November, “Genuity said that the [bankruptcy liquidation] plan speciﬁes payments that

are to be made to the company’s creditors. Stockholders will not receive any distribution under the

liquidation plan”.

1

Other U.S. companies that went bankrupt where stockholders lost all their in-

vestment include Williams Communications, Cray Computer, B&M, Continental, Mortgages GAC,

and others. We examine many of these ﬁrms in our paper. Also, in agreement with these facts,

our study answers research calls, among others, by Leland (1994, p. 1221) who writes that “stock

option pricing models ...need to reﬂect...the possibility that the value of equity reaches zero with

positive probability”.

Bankruptcy probabilities implied by stock and stock option prices can yield valuable insights

for at least three contexts: bankruptcy reorganization and liquidation, ﬁnancial distress and capital

structure, and risk management. Smith and Stultz (1985) have shown that ﬁrms facing bankruptcy

risk should hedge, and Brown and Toft (2002) derive the optimal hedging strategy for ﬁrms that

face bankruptcy and other deadweight costs. Hence, our paper also shares with a line of research,

represented by Altman (1968) and Altman, Haldeman, and Narayanan (1977), the recognition that

it is important to predict the possibility of bankruptcy.

2

These authors developed econometric

models that use accounting ratios and market-driven ratios to explain bankruptcy.

Another relevant strand of literature looks at equity as a barrier option on the assets of the

ﬁrm, where bankruptcy is triggered by the barrier (see Toft and Prucyk, 1997, and Brockman and

Turtle, 2003).

3

In our paper, instead of modeling the ﬁrm value, we take the stock price process as

1

Web Host Industry Review, http://thewhir.com/marketwatch/gen061203.cfm and gen112803.cfm.

2

See Altman (1993) for comprehensive reviews of this line of research.

3

Toft and Prucyk (1997) value a call option written on equity as a compound down-and-out barrier option, where

the equity process is given by the diﬀerence between the asset and the bond processes of the ﬁrm. Brockman and

Turtle (2003) value equity as a down-and-out call option written on the assets of the ﬁrm where the strike price is

the promised future debt payment required on the bonds issued by the ﬁrm. Their closed-form valuation equations

depend on the value of the assets of the ﬁrm, ﬁrm volatility, bond parameters, the bankruptcy trigger which is linked

to ﬁrm and bond values, and other usual parameters.

4

exogenous. Hence our paper distinguishes from these works, since we propose the use of individual

stocks and options on individual stocks to obtain information on ﬁnancial distress. Neither the

value of the ﬁrm nor the value of the bonds directly aﬀect our models.

4

In general, it is not appropriate to assume that it is possible to construct and to maintain a

continuously dynamic hedging portfolio for distressed ﬁrms and ﬁrms that have ﬁled for bankruptcy.

Hence, instead of the hedging arguments used by Black and Scholes (1973) to derive option prices,

we use equilibrium arguments similar to those of Rubinstein (1976), Brennan (1979), Stapleton and

Subrahmanyam (1984), Amin and Ng (1993), and Camara (2003) to obtain pricing formulae.

5

In

the actual world or under the actual probability measure the stock price depends on the proba-

bility of bankruptcy, a location parameter, and a scale parameter. Then using simple relations in

equilibrium, we eliminate from the option pricing equations not only preferences and the location

parameter, but also the scale parameter. These are substituted by the risk free rate of return and

the stock volatility, parameters which do not aﬀect the process of the stock under the actual prob-

ability measure. The probability of bankruptcy does not change from the actual to the risk-neutral

world.

Overall, our model and empirical evidence illustrate potential applications of this new valuable

measure of bankruptcy risk. To present our model and ﬁndings, we proceed as follows. Section

2 presents the assumptions underlying our theory. Section 3 derives preference-dependent pricing

equations. Section 4 obtains preference-free option pricing equations. Section 5 provides the em-

pirical tests of the model for ﬁrms that ﬁle Chapter 11 bankruptcy protection and global ﬁrms

impacted by subprime crisis. Section 6 concludes.

4

Cremers, Driessen, Maenhout, and Weinbaum (2004) and Carr and Wu (2006) use stock options as information

sources for credit default swaps.

5

Schroder (2004) derives general conditions for this equilibrium option pricing approach.

5

2 The economic framework

This section starts by presenting our assumptions on preferences and processes for consumption

and the stock price. The assumption that the stock price follows a delta-geometric random walk,

to the best of our knowledge, was not done previously in modern ﬁnance theory. Then, we use this

assumption to derive the stock-speciﬁc pricing kernel. The option pricing formulae derived in this

article is based on four assumptions.

Assumption 1 (Representative agent) There is a representative agent who maximizes:

E

¸

T

¸

t=0

U

t

(C

t

) | F

0

¸

, (1)

where:

U

t

(C

t

) = ρ

t

C

1−b

t

/(1 −b),

E is the expectations operator, U

t

(C

t

) is the utility function of consumption at date t, ρ is the time

discount factor, b is the coeﬃcient of proportional risk aversion, and F

0

is the information set

available to the investor at date t = 0.

This paper derives prices for options at dates t (t = 0, 1, 2, ...) that mature at date T. As-

sumption 1 implies that, at t = 0, the pricing kernel implicit in option prices that mature at T is

given by the following equation:

φ

0,T

(C

0,T

) =

U

(C

T

)

U

(C

0

)

= ρ

T

C

T

C

0

−b

. (2)

There is only one pricing kernel in the economy, which is implicit in the valuation of all

assets and is dependent on aggregate consumption. The uncertainty in this economy is driven

by the realization of two random variables at each discrete date. These are the random shocks

to consumption

c,t

and to the stock price

s,t

. The information set of the investor at date t is

represented by the σ−algebra F

t

≡ σ((

c,τ

,

s,τ

); τ = 0, 1, ..., t).

6

Assumption 2 (Consumption process) Aggregate consumption follows a geometric random

walk:

C

t

= C

t−1

c,t

, (3)

where {

c,t

} is a sequence of independent positive random variables having the same distribution

6

such that E[ln(

c,t

) | F

0

] = µ

c

−

1

2

σ

2

c

and V ar[ln(

c,t

) | F

0

] = σ

2

c

.

Assumption 2 implies that at the end of each period and, in particular, at date T consumption

C

T

is lognormally distributed:

C

T

∼ Λ

¸

ln(C

0

) +µ

c

T −

1

2

σ

2

c

T, σ

2

c

T

. (4)

Aggregate consumption growth, between 0 and T, has an expected or mean rate equal to µ

c

T

and a volatility or standard deviation equal to σ

c

√

T.

Assumption 3 (Stock price process) The stock price follows a delta-geometric random

walk:

S

t

=

0

S

t−1

s,t

(5)

where {

s,t

} is a sequence of independent non-negative random variables such that:

(i) P(

s,t

= 0) = δ

t

,

(ii) E[ln(

s,t

) |

s,t

= 0] = µ

s,t

−

1

2

σ

2

s,t

, V ar[ln(

s,t

) |

s,t

= 0] = σ

2

s,t

.

Then at the end of each period and, in particular, at date T the stock price S

T

has a delta-

lognormal distribution:

7

S

T

∼ ∆

¸

1 −

T

¸

t=1

(1 − δ

t

), ln(S

0

) +

T

¸

t=1

µ

s,t

−

1

2

T

¸

t=1

σ

2

s,t

,

T

¸

t=1

σ

2

s,t

¸

, (6)

6

As remarked by Rubinstein (1976), stationary consumption is not a necessary condition to price options in

discrete-time economies. However, it simpliﬁes the notation and focus the paper on the pricing of the options.

7

The delta-lognormal distribution is due to Aitchison (1955).

7

which means that:

P(S

T

< 0) = 0;

P(S

T

= 0) = 1 −

T

¸

t=1

(1 −δ

t

);

P(S

T

< Z) = 1 −

T

¸

t=1

(1 −δ

t

) +

T

¸

t=1

(1 −δ

t

)Λ

¸

ln(S

0

) +

T

¸

t=1

µ

s,t

−

1

2

T

¸

t=1

σ

2

s,t

,

T

¸

t=1

σ

2

s,t

¸

, Z > 0.

The expected value and the variance of stock returns, considering the distribution of S

T

given

by formula (6), are given by

8

:

E

S

T

S

0

| F

0

=

T

¸

t=1

(1 −δ

t

)exp

T

¸

t=1

µ

s,t

, (7)

V ar

S

T

S

0

| F

0

=

T

¸

t=1

(1 −δ

t

)exp

T

¸

t=1

2µ

s,t

exp

T

¸

t=1

σ

2

s,t

−

T

¸

t=1

(1 − δ

t

)

, (8)

where µ

s,t

is a location parameter (and not the expected return) of a delta-geometric random walk

at t. In this sense σ

s,t

is the scale parameter (and not the standard deviation) of a delta-geometric

random walk at t. The probability of bankruptcy up to date T is 1 −

¸

T

t=1

(1 − δ

t

), while the

probability of bankruptcy at a particular date t conditional on no earlier bankruptcy is δ

t

. None

of these parameters is stochastic.

It should be underlined that while the assumptions involve the actual location and scale pro-

cesses of the delta-geometric random walk, neither of these variables enters into the preference-free

closed-form option pricing solutions derived in the sequel. Initially, in our economy, the stock spe-

ciﬁc pricing kernel depends on preference parameters, and the actual location and scale parameters

of the stock price. When we derive equilibrium prices for the stock and the options then there

is no arbitrage and the call-put parity holds. At this stage the location and the scale parameters

can be eliminated, i.e. they are substituted by the risk-free rate and the stock volatility. The

location parameter is eliminated from option prices when the fundamental equilibrium relation of

the economy is used in these option prices to eliminate preference parameters. The scale parameter

8

The moments of an actual delta-lognormal stochastic variable are given by Aitchison and Brown (1957, p. 95).

8

is substituted in equilibrium by the stock volatility using the relations between the lognormal and

the delta-lognormal. The probability of bankruptcy is a parameter that does not change from the

actual delta-lognormal cumulative distribution function to the risk-neutral delta-lognormal cumu-

lative distribution function.

The skewness and the kurtosis of the distribution of S

T

/S

0

, considering the distribution given

by formula (6), are given by the following equations:

Ske

S

T

S

0

| F

0

=

ω

3

−3

¯

δω + 2

¯

δ

2

¯

δ

1/2

(ω −

¯

δ)

3/2

, (9)

Kur

S

T

S

0

| F

0

=

ω

6

−4

¯

δω

3

+ 6

¯

δ

2

ω −3

¯

δ

3

¯

δ(ω −

¯

δ)

2

, (10)

where:

¯

δ =

T

¸

t=1

(1 −δ

t

),

ω = exp

T

¸

t=1

σ

2

s,t

.

The delta-lognormal distribution has no probability density function (pdf) in a rigorous sense.

However, as pointed by Dennis and Patil (1988, p. 325), the delta-lognormal has a “pseudo-pdf”

given by:

g(S

T

) =

¸

1 −

T

¸

t=1

(1 −δ

t

)

¸

f

1

(S

T

) +

T

¸

t=1

(1 −δ

t

)f

2

(S

T

)

where f

2

(S

T

) is a lognormal pdf, and f

1

(S

T

) is a dirac-delta function.

9

Assumption 4 (Bond price process) There is a zero coupon bond with the following price

process:

B

t

= e

−r(T−t)

, t = 0, 1, 2, ..., T, (11)

where r is the continuously compounded interest rate and T the maturity of the bond.

9

The dirac-delta function f1(ST ) is suppose to be inﬁnite at ST = 0 and zero otherwise. It should also have

∞

−∞

f1(ST )dST = 1. The normal random variable with mean and variance, respectively, of 0 and σ

2

converges to

the dirac-delta function f1(ST ) as σ →0.

9

Based on assumptions 1, 2, and 4 we can write down the following lemma:

Lemma 1 (Interest rate) The continuously compounded interest rate is given by:

r = −

1

T

lnE

¸

ρ

T

C

T

C

0

−b

| F

0

¸

= −ln(ρ) +bµ

c

−

1

2

bσ

2

c

−

1

2

b

2

σ

2

c

. (12)

Proofs for this and the subsequent formal results are available upon request. Lemma 1 ex-

presses the interest rate as a function of preference-based parameters. This identity will be useful

to simplify the stock-speciﬁc pricing kernel.

Option prices in our equilibrium framework are expectations with respect to a bivariate dis-

tribution of consumption and stock value. The goal of the next lemma is to reduce the dimen-

sionality of this problem by making option prices as an expectation with respect to the univariate

distribution of the individual stock. First, we deﬁne two σ-subalgebras of F

t

. The σ−subalgebra

F

st

≡ σ(

s,τ

; τ = 0, 1, ..., t) is the σ-algebra generated by the stock price process. The σ−subalgebra

F

ct

≡ σ(

c,τ

; τ = 0, 1, ..., t) is the σ-algebra generated by the consumption process. The σ-algebra

F

t

is the direct product of the σ-algebras F

st

and F

ct

, i.e. F

t

= F

st

¸

F

ct

. Then F

sT

contains

all the information about the shock to the stock price up to the expiration date of the option

T. The next lemma obtains the stock-speciﬁc pricing kernel by conditioning the pricing kernel on

the stock. The stock-speciﬁc pricing kernel will depend on preference parameters, parameters of

the consumption process, and parameters of the stock price. The stock-speciﬁc pricing kernel is

a function of the random stock price, but does not depend on random consumption. Hence, the

stock-speciﬁc pricing kernel is a function of this individual stock.

Lemma 2 (Stock-speciﬁc pricing kernel) The pricing kernel φ

0,T

(C

0,T

) conditional on

F

0

∨ F

sT

is given by:

φ

0,T

(S

0,T

) = E

¸

ρ

T

C

T

C

0

−b

| F

0

∨ F

sT

¸

(13)

10

= exp

bRσ

c

√

T

¸

T

t=1

σ

2

s,t

1/2

¸

ln(S

0

) +

T

¸

t=1

µ

s,t

−

1

2

T

¸

t=1

σ

2

s,t

−ln(S

T

)

¸

−

1

2

b

2

R

2

σ

2

c

T −rT

.

where R is the correlation between the normal variates underlying consumption and the stock price.

The stock-speciﬁc pricing kernel (13) is positive and has a lognormal distribution:

φ

0,T

(S

0,T

) ∼ Λ

¸

−rT −

1

2

b

2

R

2

σ

2

c

T, b

2

R

2

σ

2

c

T

, (14)

implying that there are no arbitrage opportunities between the individual stock and derivatives

written on this stock. This stock-speciﬁc pricing kernel can only be used to discount that individual

stock and derivatives written on that individual stock. The next section will use this stock-speciﬁc

pricing kernel as a stochastic discount factor to price call and put options. Note that there are as

many stock-speciﬁc pricing kernels in the economy as the number of individual stocks.

3 Preference-dependent pricing models

This section investigates the pricing of European call and put stock options that mature at date

T and have a strike price K. The prices of European call and put options, considering assumption

1, are given by the following formulae:

P

c

= E

¸

ρ

T

C

T

C

0

(S

T

−K)

+

| F

0

, (15)

P

p

= E

¸

ρ

T

C

T

C

0

(K −S

T

)

+

| F

0

. (16)

The next lemma uses the stock price process given by assumption 3 and the stock-speciﬁc

pricing kernel given by lemma 2 to derive closed-form solutions for the prices of the options.

Lemma 3 (Preference-dependent option prices) The prices of European call and put

options with a strike price K and a maturity date T are given by the following formulae:

P

c

= S

0

G(F

0

)N(d

1

) −

T

¸

t=1

(1 −δ

t

) Ke

−rT

N(d

2

), (17)

P

p

=

¸

1 −

T

¸

t=1

(1 − δ

t

)

¸

Ke

−rT

+

T

¸

t=1

(1 −δ

t

) Ke

−rT

N(−d

2

) −S

0

G(F

0

)N(−d

1

), (18)

11

where:

d

1

=

ln

S

0

Q(F

0

)

K

+

¸

T

t=1

σ

2

s,t

¸

T

t=1

σ

2

s,t

1/2

,

d

2

= d

1

−

¸

T

¸

t=1

σ

2

s,t

¸

1/2

,

G(F

0

) = exp

−bRσ

c

√

T

T

¸

t=1

σ

2

s,t

1/2

+

T

¸

t=1

µ

s,t

− rT +

T

¸

t=1

ln(1 − δ

t

)

¸

¸

,

Q(F

0

) = exp

−bRσ

c

√

T

T

¸

t=1

σ

2

s,t

1/2

+

T

¸

t=1

µ

s,t

−

1

2

T

¸

t=1

σ

2

s,t

¸

¸

,

and N(.) is the cumulative distribution function of a standard normal random variable.

Equations (17) and (18) are not preference-free option pricing equations since they depend

on the preference parameter b, the parameter of the consumption process σ

c

, and the correlation

between the normal variates underlying consumption and the stock price R. The next lemma gives

the equilibrium relation that supports the option prices given by equations (17) and (18). The result

is obtained using the call-put parity. This parity holds since there are no arbitrage opportunities

in the economy.

Lemma 4 (Underlying equilibriumrelationship) The underlying equilibrium of the econ-

omy is given by:

rT −

T

¸

t=1

ln(1 −δ

t

) =

T

¸

t=1

µ

s,t

−bRσ

c

√

T

T

¸

t=1

σ

2

s,t

1/2

. (19)

This underlying equilibrium relation holds for the stock. The next section will use this un-

derlying equilibrium relation in the price of the options to eliminate preference-based parameters

from option prices and to derive preference-free option prices.

4 Preference-free option prices

This section derives preference-free closed-form solutions for the pricing of European call and

put options written on individual stocks. The more general result of this section, which is presented

12

in the next theorem, assumes that the volatility of the logarithmof stock returns and the probability

of bankruptcy follow nonstationary processes. Then we state two important special cases of this

theorem as corollaries. The ﬁrst corollary assumes that the volatility of the logarithm of stock

returns follows a stationary process, but that the probability of bankruptcy follows a nonstationary

process. The second corollary assumes that the volatility of the logarithm of stock returns and the

probability of bankruptcy followstationary processes. This model is useful, for example, when one is

interested in obtaining a single implied volatilityand a single implied probability of bankruptcy from

stock and stock option market prices. The preference-free option pricing equations are obtained

when we use the underlying equilibrium given by equation (19) in the preference-dependent option

pricing equations (17) and (18) to eliminate preference-parameters from these valuation equations.

Theorem (Option prices with nonstationary bankruptcy probability and nonsta-

tionary volatility) The prices of European call and put options with a strike price K and a

maturity date T are given by the following formulae:

P

c

= S

0

N(d

1

) −

T

¸

t=1

(1 −δ

t

) Ke

−rT

N(d

2

), (20)

P

p

=

¸

1 −

T

¸

t=1

(1 −δ

t

)

¸

Ke

−rT

+

T

¸

t=1

(1 − δ

t

) Ke

−rT

N(−d

2

) −S

0

N(−d

1

), (21)

where:

d

1

=

ln

S

0

K

+rT +

1

2

¸

T

t=1

σ

2

t

−

1

2

¸

T

t=1

ln(1 − δ

t

)

¸

T

t=1

σ

2

t

+

¸

T

t=1

ln(1 −δ

t

)

1/2

,

d

2

= d

1

−

¸

T

¸

t=1

σ

2

t

+

T

¸

t=1

ln(1 −δ

t

)

¸

1/2

,

N(.) is the cumulative distribution function of a standard normal random variable, and σ

t

is the

volatility of the logarithm of stock returns at date t.

The theorem provides the more fundamental and general results presented in this paper.

Pricing equations (20) and (21) do not depend on preference parameters. They depend on the

current stock price S

0

, the strike price K, the interest rate r, the time-to-maturity of the option T,

13

the probability of bankruptcy 1 −

¸

T

t=1

(1 −δ

t

) and the volatility of the logarithm of stock returns

σ

t

. Note that neither the location parameter of the stock µ

s,t

nor the scale parameter of the stock

σ

s,t

aﬀect option prices.

The preference-free delta-lognormal distribution implicit in option prices (20) and (21) can be

written as:

S

T

∼ ∆

¸

1 −

T

¸

t=1

(1 −δ

t

) , ln(S

0

) +rT −

1

2

T

¸

t=1

σ

2

t

−

3

2

T

¸

t=1

ln(1 −δ

t

) ,

T

¸

t=1

σ

2

t

+

T

¸

t=1

ln(1 −δ

t

)

¸

.

(22)

It is easily veriﬁed that the ﬁrst four moments of stock returns, considering the distribution

given by formula (22), are given by:

E

¸

S

T

S

0

| F

0

= e

rT

, (23)

V ar

¸

S

T

S

0

| F

0

= e

2rT

(ω

r

−1) , (24)

Ske

¸

S

T

S

0

| F

0

=

ω

3

r

¯

δ − 3ω

r

+ 2

(ω

r

−1)

3/2

, (25)

Kur

¸

S

T

S

0

| F

0

=

ω

6

r

¯

δ

3

− 4

¯

δω

3

r

+ 6ω

r

−3

(ω

r

−1)

2

, (26)

where:

¯

δ =

T

¸

t=1

(1 −δ

t

),

ω

r

= exp

T

¸

t=1

σ

2

t

.

The next corollary incorporates a nonstationary bankruptcy probability process in the Black-

Scholes (1973) valuation equations.

Corollary 1 (Call and put option prices with nonstationary bankruptcy probability

and stationary volatility) The prices of European call and put options with a strike price K and

a maturity date T are given by the following formulae:

P

c

= S

0

N(d

1

) −

T

¸

t=1

(1 −δ

t

) Ke

−rT

N(d

2

), (27)

14

P

p

=

¸

1 −

T

¸

t=1

(1 −δ

t

)

¸

Ke

−rT

+

T

¸

t=1

(1 − δ

t

) Ke

−rT

N(−d

2

) −S

0

N(−d

1

), (28)

where:

d

1

=

ln

S

0

K

+

r +

1

2

σ

2

T −

1

2

¸

T

t=1

ln(1 −δ

t

)

σ

2

T +

¸

T

t=1

ln(1 −δ

t

)

1/2

,

d

2

= d

1

−

¸

σ

2

T +

T

¸

t=1

ln(1 − δ

t

)

¸

1/2

,

N(.) is the cumulative distribution function of a standard normal random variable, and σ is the

volatility of the logarithm of stock returns.

Corollary 1 shows that option prices depend on the current stock price, the strike price, the

interest rate, the time-to-maturity of the option, the probability of bankruptcy, and the volatility

of the logarithm of stock returns. They are independent of the location parameter and the scale

parameter of the stock. The preference-free delta-lognormal distribution implicit in option prices

(27) and (28) is given by:

S

T

∼ ∆

¸

1 −

T

¸

t=1

(1 −δ

t

) , ln(S

0

) +rT −

1

2

σ

2

T −

3

2

T

¸

t=1

ln(1 −δ

t

) , σ

2

T +

T

¸

t=1

ln(1 −δ

t

)

¸

. (29)

The ﬁrst four moments of S

T

/S

0

implicit in the option valuation equations (27) and (28) are

still given by equations (23), (24), (25), and (26), but now

¯

δ and ω

r

are given by:

¯

δ =

T

¸

t=1

(1 − δ

t

),

ω

r

= exp

σ

2

T

.

Equations (23) and (24) do not depend on the probability of bankruptcy. This implies that

the risk-neutral lognormal implicit in the Black-Scholes valuation equations and the risk-neutral

delta-lognormal implicit in the option pricing equations (27) and (28) have identical mean (23) and

variance (24). This provides intuition to the fact that σ is the well known volatility parameter or

standard deviation of the logarithm of stock returns used in the Black-Scholes model. The scale

parameter of the stock was substituted in equilibrium by the stock volatility.

15

The next corollary simpliﬁes the option pricing problem. The closed-form solutions for the

pricing of options will depend only on observables, a single volatility parameter, and a single

bankruptcy probability parameter.

Corollary 2 (Call and put option prices with stationary bankruptcy probability

and stationary volatility) The prices of European call and put options with a strike price K and

a maturity date T are given by the following formulae:

P

c

= S

0

N(d

1

) − (1 − δ)

T

Ke

−rT

N(d

2

), (30)

P

p

=

1 −(1 −δ)

T

Ke

−rT

+ (1 − δ)

T

Ke

−rT

N(−d

2

) −S

0

N(−d

1

), (31)

where:

d

1

=

ln

S

0

K

+

r +

1

2

σ

2

T − ln(1 −δ)

T/2

[σ

2

+ln(1 −δ)]

1/2

√

T

,

d

2

= d

1

−

σ

2

+ln(1 −δ)

1/2

√

T,

and N(.) is the cumulative distribution function of a standard normal random variable.

The preference-free delta-lognormal distribution implicit in option prices (30) and (31) is given

by:

S

T

∼ ∆

¸

1 −(1 −δ)

T

, ln(S

0

) +rT −

1

2

σ

2

T − ln(1 − δ)

3

2

T

, σ

2

T + ln(1 −δ)

T

. (32)

The ﬁrst four moments of S

T

/S

0

implicit in the option valuation equations (30) and (31) are

still given by equations (23), (24), (25), and (26), but now

¯

δ and ω

r

are given by:

¯

δ = (1 −δ)

T

,

ω

r

= exp

σ

2

T

.

When δ = 0 in equations (30) and (31) then the Black-Scholes (1973) model obtains. Equations

(30) and (31) also lead to Merton’s (1976) ruin option pricing model. The ruin option pricing model

of Merton (1976) assumes that the stock price follows a jump–diﬀusion process with a jump size of

16

-100 percent when the jump occurs:

dS = (µ

s

+ λ)Sdt +σ

s

SdW −Sdq,

where dW is the actual standard Gauss-Wiener process, dq the actual Poisson process with Prob(dq =

1) = λdt, and λ is the mean number of jumps per unit of time. Our scale parameter σ

2

s

in Mer-

ton’s words is the instantaneous variance of the return, conditional on the no occurrence of jumps.

Merton’s ruin option pricing model depends on σ

s

and λ rather than on σ and δ as in Corollary 2.

We obtain Merton’s model from Corollary 2 in two steps. First, we have σ

2

s

= σ

2

+ ln(1 − δ). We

substitute this equation into d

1

and d

2

of Corollary 2, and rewrite:

d

1

=

ln

S

0

K

+

r − ln(1 − δ) +

1

2

σ

2

s

T

σ

s

√

T

,

d

2

= d

1

− σ

s

√

T.

Now deﬁne λ = −ln(1 − δ) or (1 − δ)

T

= e

−λT

. Substituting this relation into d

1

, d

2

, (30),

and (31) yields the Merton’s ruin option pricing model:

P

c

= S

0

N(d

1

) −Ke

−(r+λ)T

N(d

2

),

P

p

=

1 − e

−λT

Ke

−rT

+Ke

−(r+λ)T

N(−d

2

) − S

0

N(−d

1

),

where:

d

1

=

ln

S

0

K

+

r +λ +

1

2

σ

2

s

T

σ

s

√

T

,

d

2

= d

1

−σ

s

√

T,

which depends on σ

s

and λ rather than on σ and δ of Corollary 2. While in Corollary 2 the

probability that the stock price goes to zero is δ, in Merton’s ruin option pricing model the prob-

ability that the stock price goes to zero is λdt. Hence our Corollary 2 is equivalent to Merton’s

(1976) ruin option pricing model with a diﬀerent interpretation of parameters. An inspection of

the formulas shows that while Merton’s model allows one to recover the mean number of jumps per

17

unit of time λ from option prices, our model permits us to recover the probability of bankruptcy δ

implicit in option market prices. However, it seems unlikely that one could recover the probability

of bankruptcy from market prices using Merton’s model without the relation that we establish in

this paper between δ and λ, λ = −ln(1 − δ). In the next section, equations (30) and (31) are

going to be inverted to yield simultaneously the bankruptcy probability δ and the volatility σ as

functions of the other variables. The results are the implied bankruptcy probability and implied

volatility by option market prices.

10

5 Empirical testing of the model

5.1 Sample selection and data sources

To empirically test the model, we use two diﬀerent data sets. First, we select ﬁrms where

stockholders face substantial bankruptcy risk. One of our main empirical objectives is to analyze

ﬁrms that were inﬂuenced by the subprime mortgage crisis. To accomplish this for our second

data set, we analyze all ﬁnancial ﬁrms, selected building construction ﬁrms and business services

companies that have traded stock options. This makes it possible to examine the global impact of

the subprime crisis from a bankruptcy perspective.

To construct the ﬁrst sample, we investigate the largest U.S. ﬁrms that ﬁled for Chapter 11

bankruptcy protection and that have traded stock options during the period January 1998 through

December 2006. Information on the largest bankruptcies is obtained from the Bankruptcy Data

Division of New Generation Research, a provider of bankruptcy information on U.S. public and

private ﬁrms. We include all bankruptcies during this time period for ﬁrms with total assets greater

than one billion dollars and also include the top 15 to 20 largest bankruptcies in each year, even if

total assets are less than one billion dollars. This allows us to test the model on several bankruptcies

10

This can be implemented using, for example, a Newton-Raphson algorithm.

18

in each year of the sample period. Stock option data is obtained from Option Metrics, a market

vendor of option data. Of the 299 largest U.S. publicly-held ﬁrms that ﬁled Chapter 11 bankruptcy

protection over the sample period, we ﬁnd that stock options were actively traded on 109 of these

ﬁrms. Table 1 provides a list of these distressed ﬁrms together with the Chapter 11 ﬁling date and

other important information which is discussed in the following subsections.

The second universe consists of all ﬁnancial ﬁrms that have options traded with prices reported

between January 1, 2007 and May 31, 2008. OptionMetrics has option and stock price information

on 145 companies. Among them, 129 are US based and 16 are foreign based. These are categorized

into the following 12 industry groups: Money Center Banks; Regional - Northeast Banks; Regional -

Mid-Atlantic Banks; Regional - Southeast Banks; Regional - Midwest Banks; Regional - Southwest

Banks; Regional - Paciﬁc Banks; Foreign Money Center Banks; Foreign Regional Banks; Savings &

Loans; and Investment Brokerage - National; Investment Brokerage - Regional and Credit Services.

As part of this sample, we also select various ﬁrms in the building construction and business

services industries impacted by the subprime mortgage crisis to investigate the impact on selected

nonﬁnancial ﬁrms. Options data for these ﬁrms was also obtained from Option Metrics.

5.2 Estimating the implied probability of bankruptcy

The probability of bankruptcy δ is estimated from Equations 30 and 31. The pricing equations

are inverted to yield implied values for the volatility and the bankruptcy probability. We estimate

values for these parameters by minimizing the sum of squared errors for each ﬁrm on each day.

We restrict our analysis to options with maturities between two weeks and six months and exclude

options that are far out-of-the-money. Risk-free rates are obtained from Option Metrics. The

rates are calculated using the continuously compounded zero-coupon interest rate derived from

LIBOR rates and CME Eurodollar futures. Where applicable, we subtract the present value of

dividends from the stock prices. Many of the distressed ﬁrms have suspended dividends by the

19

time of our analysis. The optimization procedure restricts volatility to non-negative values and the

default probability between zero and one. In several cases we identiﬁed reported option prices that

allowed arbitrage. We eliminated these prices from our analysis. However, for some ﬁrms during

very turbulent periods the optimization procedure could not converge (for example Bear Stearns

after March 12, 2008). If the optimization does not converge on a given date, that observation is

dropped. It is also possible in such days that the optimization procedure produces either zero or

one as an optimal result. If the estimate is zero, we report the average default probability of the

last ﬁve days on that particular day. If the estimate is one, we keep it in our analysis. Note, that

this estimate is an expected value, so default probability of one should not be interpreted as an

”imminent” bankruptcy but as an extreme increase in the potential future troubles for that ﬁrm.

Estimates for the implied probability of bankruptcy are statistically signiﬁcant at the 5 percent

conﬁdence level.

5.3 Analysis of ﬁrms that have ﬁled for Chapter 11 bankruptcy protection

Table 1 presents the results for the implied probability of bankruptcy (delta) estimated for the

sample of 109 distressed ﬁrms. The mean delta is estimated as the average value for the most

recent six days in which data was available, the estimate was statistically signiﬁcant, and in which

the optimization procedure converges. Using the average delta over six trading days provides a

better estimate than using the estimate for one day. For example, it is not uncommon for deltas to

change by several percentage points daily when examining this group of distressed ﬁrms. The table

also lists the last date for which the bankruptcy probability can be estimated, the number of days

prior to bankruptcy ﬁling that the probability is estimated, the senior long-term debt rating, and

the ﬁrm’s total assets for the year preceding the bankruptcy ﬁling. The senior long-term debt rating

is based on Standard and Poor’s (S&P) Long-Term Senior Issuer Credit (or Moodys if S&P is not

available) and is obtained from Bloomberg on the exact date in which the last delta is estimated.

20

Debt ratings were available for 74 of the ﬁrms through Bloomberg. For the remaining 35 ﬁrms,

debt ratings were obtained for 18 of the companies through Compustat for the month in which the

last delta is estimated. Debt ratings were not available for the remaining 17 ﬁrms.

The mean delta is 24.5 percent for the group. The highest probability of bankruptcy is esti-

mated for Mariner Post-Acute (69.5 percent) and the lowest probability of bankruptcy is estimated

for Covanta Energy Corporation (1.5 percent). Interestingly, the delta for Mariner Post-Acute is

estimated 325 days prior to bankruptcy ﬁling. At the time, the S&P credit rating was B+ which

indicates ”a greater vulnerability to default but currently has the capacity to meet interest pay-

ments and principal repayments”. Given the high delta of 69.5 percent, this implies that the model

is useful in assessing the high probability of bankruptcy long before the Chapter 11 petition is

actually ﬁled. The model is also useful to gauge ﬁrm risk in which debt ratings are unavailable.

For example, for Motient Corporation, the delta is 66.4 percent 291 days before bankruptcy and

debt ratings are not listed for this company.

Table 2 shows the delta calculated for distressed ﬁrms sorted according to industry group and

year of bankruptcy ﬁling. The largest number of bankruptcies (32) for sample ﬁrms occurred in

2001 and the fewest bankruptcies (3) were in 2006. The mean deltas for these years are 23.5 and

25.2 percent, respectively. The largest yearly mean delta of 32.9 percent occurs in 2000 and the

lowest of 21.7 percent occurs in 2003. For industry groups with more than one ﬁrm, the highest

mean delta is 32.9 for Transportation by Air (SICs 4500-4599, 7 ﬁrms) and the lowest is 14.2 percent

for Electric, Gas and Sanitary Services (SICs 4900-4999, 5 ﬁrms). Most bankruptcies (26 ﬁrms)

occurred in the Communications Industry (SICs 4800-4899) with a mean delta of 25.4 percent. On

the whole, it is clear that the results are not driven by one particular industry or bankruptcy year.

It is useful to compare the model for a sample of healthy ﬁrms. For this reason, we choose ﬁrms

in the Standard and Poors 500 (S&P500). All ﬁrms in the S&P500 are selected on which options

are actively traded during the period June through July 2006. We calculate mean deltas for each of

21

these 362 ﬁrms during this time frame. Panel A of Table 3 summarizes the minimum, maximum,

quartiles, means, standard deviations, and ranges for the probability of bankruptcy for the two

sample groups: distressed ﬁrms and S&P500 ﬁrms. As shown, the mean deltas (maximum deltas)

are 24.49 (69.46) and 1.92 (8.19) percent for distressed ﬁrms and S&P500 ﬁrms, respectively. Panel

B presents univariate tests of diﬀerences in mean and median values for the deltas. The t-statistic

provides a test of the null hypothesis that the mean values of the probability of bankruptcy do

not diﬀer between the two groups. The Wilcoxon sign-rank Z-statistic provides a test of the null

hypothesis that the median values do not diﬀer. As shown in Panel B, the hypothesis of equal

implied probabilities of bankruptcy is rejected at the one percent signiﬁcance level as both the

mean and median values are signiﬁcantly higher for our sample of distressed ﬁrms.

In order to determine how our implied probability of bankruptcy compares with other proxies

for ﬁrm risk, we analyze the relation between delta and other measures such as the S&P debt rating,

the S&P common stock rating, and the Altman z-scores. The S&P common stock rating is obtained

from Compustat for the same month in which the last delta was estimated. Z-scores are obtained

from Compustat and are for the most recent year prior to bankruptcy ﬁling for distressed ﬁrms

(or the closest year available) and for year-end 2005 for S&P500 ﬁrms. The z-score is an ordinal

measure and has no direct probabilistic interpretation. Likewise, none of the other measures provide

a direct probabilistic interpretation of bankruptcy or default. A key innovation of our model is that

we can get a direct sense of the risk of the company by looking at the bankruptcy probability. For

example, for Trans World Airlines (TWA), we can make the following statement: ”As of June 28,

2000, we estimated that there is an implied probability of probability of 61.1 percent that the ﬁrm

will go bankrupt within the next six months.”

It is interesting to note that approximately seven months later, on January 10, 2001, TWA

ﬁled Chapter 11.

Table 4 reports these results. Panel A compares the mean delta for distressed ﬁrms versus

22

S&P500 ﬁrms sorted according to the debt rating. As shown, the lowest delta is obtained for the

ﬁrms with the highest quality debt rating for both groups and vice versa. With the exception

of distressed ﬁrms rated B, the delta increases monotonically consistent with the higher risk debt

ratings for both groups. The S&P historical global average one-year default rate is also listed for

comparison purposes. Note that the global average default rate for ﬁrms rated CCC and below is

similar to the delta estimated from our distressed ﬁrm sample (28.83 percent for S&P verses 27.79

and 30.54 percent for our distressed ﬁrms). It is important to note that these are average default

rates and that during periods of economic weakness, defaults and downgrades may be higher.

Panel B lists mean values for delta, the z-score, S&P debt rating, and S&P common stock

rating for the sample of distressed ﬁrms. Firms are grouped into four quartiles based on the delta.

Only ﬁrms in which the delta is estimated within one year of Chapter 11 ﬁling are included. Z-

scores are not included in this panel if the value is not obtained within one year of the bankruptcy

ﬁling date. It appears that neither the S&P debt rating nor the S&P equity distinguishes as well

as the delta and z-score for distressed ﬁrms. While there is not an overall trend for the relation

between size and probability of bankruptcy, the quartile for the highest delta has the lowest mean

ﬁrm size.

To examine whether an increase of the probability of bankruptcy δ precedes the debt rating

change for our sample ﬁrms, we conduct additional analysis and present these results in Panel C.

Analysis is restricted to ﬁrms with deltas greater than 14 percent and whose credit rating is available

through Bloomberg. We ﬁnd that delta increases implying a high probability of bankruptcy can

lead the debt rating change by a period of up to six months. Interestingly, the delta leads the debt

rating change by the longest period (two to six months) for sample ﬁrms with ratings of BB or

higher.

Figure 1 illustrates the delta for one of our sample ﬁrms, Dana Corporation, over the period

January 3, 2005 up until ten days before Chapter 11 bankruptcy was ﬁled. On January 3, 2005,

23

the delta was ﬁve percent and by February 22, 2006, it had increased to 30 percent. On October

9, 2005, Dana’s management and Audit Committee determined, as a result of ongoing internal

investigations, that the company had not properly accounted for certain items during 2004 and

the ﬁrst and second quarters of 2005, and concluded that Dana’s ﬁnancial statements for those

periods should no longer be relied upon and should be restated. On October 10, 2005, Dana issued

a news release reporting these items and also reported the write-oﬀ of its U.S. deferred tax assets.

Over these two days, the delta increased to 29 percent. Clearly, the model captures the increased

bankruptcy probability of the ﬁrm over time.

Perhaps one of the most famous unexpected bankruptcies in recent times is the December 2,

2001 bankruptcy of Enron. Figure 2 illustrates the delta for Enron over the period January 1999

through December 2, 2001. As shown, the delta value is estimated at 14.2 percent on October 15th,

the day before Enron announced adjustments to earnings and equity reductions. By mid-November,

the implied delta was over 39 percent which demonstrates the model’s usefulness in capturing the

increased bankruptcy risk of a ﬁrm, even a ﬁrm subject to fraud.

5.4 Analysis of the subprime mortgage crisis and its replications around the

world

An important and highly useful application of the model is to analyze the impact of current events

as they unfold. To do this, we conduct a global analysis of ﬁrms impacted by the subprime mortgage

crisis. Because our model of risk uses contemporaneous data and does not rely on stale accounting

information, it provides additional information not available by most other models.

To test if the model captures important forward looking information about potential trouble

with ﬁrms, we investigate both global ﬁnancial ﬁrms and nonﬁnancial ﬁrms (e.g., U.S. building

construction and business services ﬁrms) impacted by the subprime crisis. One of our objectives is

to identify how the subprime mortgage crises propagated around the world: from the United States

24

regional and center banks to foreign based center and regional banks. Our analysis illustrates two

primary channels for international transmission of the subprime crisis: ”common shocks” (a con-

current impact such as experienced by money center banks globally) and ”spillover” or ”contagion”

eﬀects (a lagged impact such as experienced by the building construction, credit services and re-

gional banking sectors, which our results show as of May 2008 is still unfolding for regional banks

both in the U.S. and globally).

11

Before discussing our results for the universe of ﬁnancial institutions analyzed, we ﬁrst look

at the building construction and business services industries. These industries have experienced

the ”spillover” eﬀect from the subprime crisis due to real sector demand declines and economic

slowdown. Table 5 and Figure 3 provide these results. Table 5 lists the delta on January 3, 2007

and the maximum delta (including the date for this value) for the 9 ﬁrms analyzed. The average

delta on January 3, 2007 is 2.74 percent whereas the average maximum delta is 22.30 percent.

The diﬀerence in means is statistically signiﬁcant at the one percent level. The highest maximum

delta of 53.67 percent is obtained for PMI Group, a mortgage insurer, on March 19, 2008. A brief

explanation as to how each ﬁrm is impacted by the subprime crisis is also provided in the table.

While not included in Table 5 results, additional analysis shows that our model anticipates increases

in bankruptcy risk when debt ratings remain unchanged for this group of ﬁrms.

Figure 3 plots selected analysis from Table 5. Results are illustrated over the period January 3

through May 31, 2008. Estimates are daily averages of the delta for building construction (primarily

home builders). As shown, mean deltas are less than two percent at the beginning of the year and

remain less than ﬁve percent through mid-March. During this period, concern over the subprime

mortgage sector was at a lower level and had not reached the crisis levels of late summer. By late

August 2007, the delta for the home building industry increases dramatically reaching 15 percent

11

See Brown and Davis (2008) and Mason (2008) for additional discussion on the global impact and implications

of the subprime crisis.

25

and higher, capturing the increased risk of bankruptcy in this market sector. Since August 2007,

the mean deltas have remained steadily high.

Next, we analyze the ﬁnancial interlinkages of banking ﬁrms around the world. The results

demonstrate both the micro and macro aspects of these interlinkages for the subprime crisis globally.

Table 6 provides descriptive statistics for the entire ﬁnancial universe we study and for diﬀerent

industry groups. For the whole universe the average bankruptcy probability is 3.71 percent with

a maximum value of 9.68 percent on May 23, 2008. National and regional brokerages as well as

credit services ﬁrms have averages higher than 5 percent. The range of the maximum values for

δ is 6.93 percent(Regional northeast banks) to 32.81 percent(Regional midatlantic banks). Based

on the average (median) bankruptcy probability, brokerage houses, savings and loans and the

credit services ﬁrms are the most impacted by the subprime crisis. This results are consistent

with the observed empirical evidence - Bear Sterns, Moody’s, Washington Mutual - all fall in the

above categories. Interestingly, the highest average default probability is observed for the regional

midatlantic banks. Speciﬁcally, South Financial Group (TSFG) has a dramatic increase in the

default probability in May 2008 and at the same time, has experienced a large drop in stock price

from $20 per share to $3 per share.

Figure 4 shows the plot of the bankruptcy probability for all 145 ﬁnancial ﬁrms. Note that

there is an upward trend for the period January 2007 to May 2008. Around the Bear Stearns crisis

(March 17, 2008) one can observe a spike in the average default probability (from 6 to 9 percent).

Figure 5 plots the average bankruptcy probability for the US money center banks and foreign

money center banks. Panels A and B of Table 7 shows descriptive statistics for the individual ﬁrms

from that category. It is clear that the foreign money center banks reacted simultaneously with the

US money center banks around the Bear Sterns crisis. There was no delay in the increase of the

average default probability. This illustrates that ﬁnancial markets around the world have become

fully integrated and information gets disseminated very fast.

26

Average bankruptcy probabilities for the US regional banks are graphed in Figures 6 and

average bankruptcy probability for regional banks and foreign money center banks are graphed in

Figure 7. Table 8 shows descriptive statistics for the individual ﬁrms in the foreign regional banks

category. In these two categories, note that there is a delay in the response of the bankruptcy

probability. Their default probability has recently picked up. It will be important to observe for

how long this trend will continue.

The average bankruptcy probabilities for the US national and regional brokerage ﬁrms are

illustrated in Figure 8. Panels A and B of Table 9 provide the descriptive statistics for the individual

ﬁrms from these categories, respectively. Similar to the foreign ﬁrms category, the increase in the

default probability for the US regional brokers occurred with some delay relative to the increase

in the US national brokers. These results illustrate the ”spillover” or ”contagion” bankruptcy risk

eﬀects due to the integrated nature of global ﬁnancial markets.

Figure 9 plots the average bankruptcy probability for the credit services ﬁrms. Table 10 shows

descriptive statistics for the individual ﬁrms from that category. On August 15, 2007, Represen-

tative Barney Frank announced plans to hold hearings in the House Financial Services Committee

investigating credit rating agencies role in the subprime mortgage crisis. Most likely in reaction to

this news, the implied probability of bankruptcy for the credit services ﬁrms increased dramatically

after that announcement. On May 19, 2008, Moody’s delta had increased to a maximum level of

28.71 percent. These results further highlight the ”spillover” eﬀects of the subprime crisis into the

credit services industry.

Overall, the evidence in this section illustrates an important feature of our model: to analyze

crisis situations as they evolve and to gauge bankruptcy risk using a forward-looking measure

based on data from the option markets. We highlight the micro and macro aspects of international

ﬁnancial integration due to the subprime crisis.

In summary, the empirical results strongly support the model. We believe this model makes

27

important contributions to the literature and can be applied in a number of crucial areas of corporate

ﬁnance, including bankruptcy liquidation and reorganization. Furthermore, the model has potential

applications in other vital areas of ﬁnance including capital structure, executive compensation, and

ﬁnancial markets. For example, Bartram, Brown, and Hund (2005) obtain implied bankruptcy

probabilities using our model to study the event of a systemic failure of the global banking system.

6 Conclusions

Bankruptcy risk is of great concern to companies and businesses operating in all sectors of

ﬁnancial markets globally. Various tools and techniques have been used to assess bankruptcy risk,

most of which rely on historical data. This paper presents a forward looking measure that uses

stock and option prices to obtain an implied probability of bankruptcy. We derive option pricing

equations that are similar to Merton’s ruin model, and empirically test the model for ﬁrms that

have ﬁled for Chapter 11 and global banks that have been impacted by the subprime mortgage

crisis.

The empirical results presented strongly support the model and demonstrate that it is able to

distinguish healthy ﬁrms from distressed ﬁrms. Our bankruptcy probability estimates are generally

consistent with other measures of ﬁrm risk including z-scores, senior long-term debt ratings, and

common stock ratings. Furthermore, we ﬁnd that the increases in the bankruptcy probability can

lead debt ratings changes by a period of up to six months in selected analysis.

We also test the model on ﬁrms impacted by the subprime mortgage crisis and the results are

striking. The average default probability for the global ﬁnancial ﬁrms universe increases steadily

since January 2007. The biggest increase is observed for the credit services ﬁrms and investment

brokerage houses. It is interesting to note that foreign center banks default probabilities increase

simultaneously with the US center banks, which illustrates the ”common shock” eﬀect of global

ﬁnancial integration. However, there is an observed delay for the foreign regional banks and US

28

regional investment brokerage ﬁrms, which illustrates the ”spillover” eﬀect of the crisis. This evi-

dence suggests that the world ﬁnancial markets are highly integrated and information disseminates

very fast across the globe.

29

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31

32

Table 1

Implied Probability of Bankruptcy δ Estimated for Public Companies with Traded Options that Filed for

Chapter 11 Bankruptcy during January 1998 through December 2006

This table lists the largest public companies with traded stock options that filed for bankruptcy during January 1998

through December 2006. Chapter 11 filing date is the day that the firm filed for bankruptcy protection. The mean

implied probability of bankruptcy δ is the average value estimated over the last six days for which data was

available and for which the optimization procedure converges. Also provided are the last date for which the

bankruptcy probability could be estimated, the number of days prior to bankruptcy filing that the last bankruptcy

probability is estimated, and the S&P senior long-term debt rating. The implied probability of bankruptcy δ is

estimated using Equations 30 and 31. Total assets are listed for the most recent annual report prior to bankruptcy.

Company Chapter 11

Filing Date

δ (%) Last Date

Estimated

Days to

Ch.11

Debt

Rating

Total

Assets

(Million)

360Networks (USA) 6/28/2001 12.6 2/26/2001 122

B+

$5,596.0

aaiPharma 5/10/2005 30.8 3/4/2005 66 CCC $ 339.1

Able Laboratories 7/18/2005 5.5 7/21/2005 -3 . $ 104.3

Adelphia Business Solutions 3/27/2002 29.2 7/18/2001 249 BB- $1889.5

Adelphia Communications 6/25/2002 22.5 4/11/2002 74 B $21,499.5

Allegiance Telecom 5/14/2003 14.6 1/28/2002 466 B $1,441.2

APW Ltd 5/16/2002 10.2 10/25/2001 201 . $523.7

Arch Wireless 12/6/2001 9.9 11/9/2000 387 B $2,309.6

Armstrong World 12/6/2000 4.4 10/9/2000 57 A- $4,164.0

Atlas Air Worldwide Holdings 1/30/2004 18.6 11/15/2002 435 B- $2,084.8

Boston Chicken 10/5/1998 13.0 4/30/1998 155 CCC $2,005.0

Breed Technologies 9/2/1999 38.0 5/28/1999 94 B- $1,660.0

Burlington Industries 11/15/2001 28.6 3/2/2000 613 BB+ $1185.0

CHS Electronics 4/4/2000 11.1 6/4/1999 300 B- $3,572

Calpine Corporation 12/20/2005 12.8 9/19/2005 91 B- $27,216.1

Collins & Aikman Corporation 5/17/2005 10.7 2/7/2005 100 B+ $ 3,196.7

Comdisco 7/16/2001 10.3 4/2/2001 104 BBB $8754.0

Conseco 12/18/2002 13.0 5/28/2002 200 B $61,392.3

Covad Communications 8/15/2001 22.1 12/14/2000 241 B- $442.2

Covanta Energy Corporation 4/1/2002 1.5 12/19/2001 102 BBB $3185.8

Dana Corporation 3/3/2006 21.2 2/23/2006 10 B+ $ 9,047.0

Delphi Corporation 10/8/2005 12.2 9/2/2005 36 CCC+ $ 16,593.0

Delta Air Lines 9/14/2005 14.3 7/21/2005 53 CC $ 21,801.0

Encompass Services Corporation 11/19/2002 12.2 8/4/2000 825 BB $2401.3

Enron Corporation 12/3/2001 24.5 11/19/2001 14 BBB- $63,300.0

Exodus Communications 9/26/2001 8.5 6/1/2001 115 B $3,894.4

Federal-Mogul Corporation 10/1/2001 12.5 6/11/2001 110 B+ $10,150.0

FINOVA Group 3/7/2001 20.5 11/15/2000 112 . $14,050.0

Flag Telecom Holdings 4/12/2002 7.0 8/6/2001 246 BB- $3476.7

Fleming Companies 4/1/2003 22.1 3/6/2003 25 B- $3,654.7

Footstar 3/2/2004 24.0 12/26/2003 66 . $775.3

FPA Medical Management 7/19/1998 10.6 5/18/1998 61 B+ $831.0

Friede Goldman Halter 4/19/2001 13.0 3/13/2001 36 CCC+ $822.0

Fruit of the Loom 12/29/1999 19.8 11/17/1999 42 B- $2,289.0

FLYi 11/7/2005 45.7 2/23/2005 254 CC $866.0

Genesis Health Ventures 6/22/2000 61.2 11/29/1999 203 B $2,430.0

Genuity 11/27/2002 33.4 7/25/2001 482 BBB+ $2994.5

Global Crossing Ltd. 1/28/2002 16.2 7/23/2001 185 BB+ $30,185.0

Global TeleSystems 11/14/2001 21.7 1/18/2001 296 CCC+ $2,833.8

Harnischfeger Industries 6/7/1999 15.6 5/28/1999 9 . $2,876.0

Heilig-Meyers 6/16/2000 55.0 5/4/2000 42 BB- $1,456.0

InaCom Corporation 6/16/2000 21.1 1/5/2000 161 BB- $1103.5

ICG Communications 11/14/2000 36.2 9/11/2000 63 B- $2,020.0

Integrated Health Services 2/2/2000 14.1 7/21/1999 191 B- $5,393.0

33

Interstate Bakeries Corporation 9/22/2004 23.9 9/20/2004 2 CCC+ $1,645.7

Iridium LLC/Capital Corporation 8/13/1999 34.8 7/29/1999 14 . $3,738.0

JumboSports 12/27/1998 67.5 11/5/1997 412 CCC $467.0

Kaiser Aluminum Corporation 2/12/2002 27.0 8/28/2000 524 . $3,364.3

LTV Corporation 12/29/2000 49.5 7/21/2000 158 BB- $6,101.0

Laidlaw 6/28/2001 4.8 11/30/1999 568 BBB $4,000.0

Leap Wireless International 4/13/2003 22.6 5/2/2002 341 B- $2,163.7

Lodgian 12/20/2001 36.7 7/28/2000 502 B+ $1164.0

Loewen Group International 6/1/1999 8.6 1/12/1999 139 BB $3,738.0

Loral Space & Communications 7/15/2003 24.3 1/28/2002 527 B $2,692.8

Loews Cineplex Entertainment 2/15/2001 40.3 4/6/2000 309 BB- $1677.6

Mariner Post-Acute 1/18/2000 69.5 2/23/1999 325 B+ $3,037.0

McLeodUSA 1/30/2002 10.3 12/27/2000 393 B+ $4,755.1

Metals USA 11/14/2001 10.9 1/25/2000 649 BB- $689.9

Metricom 7/2/2001 18.2 4/16/2001 76 CCC $1253.6

Mirant Corporation 7/14/2003 24.9 7/11/2003 3 CCC+ $19,415.0

Motient Corporation 1/10/2002 66.4 3/19/2001 291 . $209.6

National Steel 3/6/2002 10.5 5/22/2000 644 B+ $2307.6

Northwest Airlines 9/14/2005 20.9 9/2/2005 12 CCC+ $14,042.0

Northwestern Corporation 9/14/2003 15.5 4/8/2003 156 B $2,672.9

OCA 3/14/2006 18.1 5/2/2005 312 . $660.3

Owens Corning 10/5/2000 36.3 9/21/2000 14 BB- $6920.0

Pacific Gas & Electric 4/6/2001 15.1 4/6/2001 0 D $29,770.0

Paging Network 7/24/2000 67.2 3/2/2000 142 D $1422.6

Paragon Trade Brands 1/6/1998 1.7 12/16/1997 20 . $373.0

Peregrine Systems 9/22/2002 43.7 6/5/2002 107 . $2003.8

Petroleum Geo-Services ASA 7/29/2003 43.3 7/30/2002 359 BBB- $4,302.8

Pillowtex Corporation 11/14/2000 26.1 8/28/2000 76 CCC $1,683.0

Pinnacle Holdings 5/21/2002 14.0 8/9/2001 282 B- $1034.3

Polaroid Corporation 10/12/2001 23.9 6/15/2001 117 CCC+ $2043.0

PSINet 5/31/2001 16.7 10/23/2000 218 B- $4,492.3

Refco 10/17/2005 4.7 10/13/2005 4 B $33,333.2

Reliance Acceptance Corp. 2/9/1998 22.6 10/3/1997 126 . $553.0

Reliance Group Holdings 6/12/2001 53.8 4/3/2000 429 BBB- $12,598.1

Rhythm NetConnections 8/1/2001 12.0 9/29/2000 302 CCC+ $1056.3

RSL Communications 3/19/2001 46.5 9/22/2000 177 B- $1803.3

Safety-Kleen 6/9/2000 4.7 1/4/2000 155 D $4,367.0

Singer Company 9/12/1999 33.7 4/30/1999 132 CCC $1753.9

Solutia 12/17/2003 10.0 10/9/2003 68 B- $3,342.0

SpectraSite Holdings 11/15/2002 54.7 1/14/2002 301 B $2578.5

Spiegel 3/17/2003 10.3 10/30/2001 497 . $1,889.6

Sun Healthcare Group 10/14/1999 14.6 1/14/1999 270 B $2,468.0

Sunbeam Corporation 2/6/2001 53.4 8/25/2000 161 CCC+ $3132.3

Sunterra Corporation 5/31/2000 4.6 1/14/2000 137 BB- $1058.4

Teligent Communications 5/21/2001 4.1 10/4/2000 227 B- $1209.5

Touch America Holdings 6/19/2003 22.0 7/26/2002 323 . $3,059.5

Tower Automotive 2/2/2006 37.2 11/5/2004 447 B+ $2291.2

Trans World Airlines 1/10/2001 61.6 6/28/2000 192 CCC $2137.2

UAL Corporation 12/9/2002 40.0 11/25/2002 14 CCC $25,197.0

Ultimate Electronics 1/11/2005 34.8 2/11/2005 -30 . $336.2

United Pan-Europe Comm. N.V. 12/3/2002 16.1 6/4/2001 539 B+ $4931.0

U.S. Airways Group 9/12/2004 23.2 7/22/2004 50 B- $8349.0

U.S. Office Products Company 3/5/2001 52.8 2/4/2000 391 B $1745.7

Vencor 9/13/1999 15.4 10/15/1999 -32 . $1,718.0

Viatel 5/2/2001 27.0 1/12/2001 110 B- $2155.4

Warnaco Group 6/11/2001 18.3 2/15/2001 116 BB $2372.7

Webvan Group 7/13/2001 29.2 9/18/2000 295 . $1521.5

Westpoint Stevens 6/1/2003 29.3 7/17/2001 674 B $1,368.9

Williams Communications Group 4/22/2002 48.1 11/28/2001 144 B $5,992.0

34

Winn-Dixie Stores 2/21/2005 10.2 2/9/2005 12 B- $2,618.9

Winstar Communications 4/18/2001 15.7 3/14/2001 34 B $4,975.4

World Access 4/24/2001 12.8 1/30/2001 84 B $1629.8

WorldCom 7/21/2002 14.9 4/18/2002 93 BBB+ $103,900.0

W.R. Grace & Company 4/2/2001 14.5 1/5/2001 87 BB+ $2509.1

XO Communications 6/17/2002 6.7 10/18/2001 239 B- $7,930.5

Mean 24.5 203 B $6876.4

35

Table 2

Mean Implied Probability of Bankruptcy δ by Industry and Year

This table shows the implied probability of bankruptcy δ by industry and year for the sample of distressed firms.

The “% of Firms” column total may not sum exactly to 100% because of rounding.

SIC Industry Group

SIC

Code

1998 1999 2000 2001 2002 2003 2004 2005 2006 N %

Firms

Mean

δ

Mining and Construction

1000-

1999

- - - - 1 1 - - - 2 1.8 27.7

Manufacturing

2000-

3999

1 3 4 10 2 3 2 2 2 30 27.5 22.7

Food and Kindred

Products

2000-

2099

- - - - - - 1 - - 1 0.9 23.9

Textile Mill Products;

Apparel and Other

2200-

2399

- 1 1 3 - 1 - 1 - 7 6.4 26.6

Paper, Printing, Chemicals

& Allied

2600-

2899

1 - - 1 - 1 1 1 - 5 4.6 15.3

Stone, Clay, etc Products;

Primary Metal Ind.

3200-

3399

- - 2 1 2 - - - - 5 4.6 26.8

Fab. Metal Prod; Ind. &

Comm. Mach & Comp

Eq; Other

3400-

3699

- 1 - 3 - - - - 1 5 4.6 30.0

Transportation Equipment

3700-

3799

- 1 - 1 - - - 1 1 4 3.7 23.1

Measuring,

Analyzing/Control Inst;

Misc. Manuf.

3800-

3999

- - 1 1 - 1 - - - 3 2.8 17.5

Transportation,

Communications, Electric,

Gas, and Sanitary Service

4000-

4999

- 1 3 12 13 5 1 4 - 39 35.8 24.8

Local and Suburban

Transit and Related

4100-

4199

- - - 1 - - - - - 1 0.9 4.8

Transportation by Air

4500-

4599

- - - 1 2 - 1 3 - 7 6.4 32.9

Communications

4800-

4899

- 1 2 9 11 3 - - - 26 23.9 25.4

Electric, Gas and Sanitary

Services

4900-

4999

- - 1 1 - 2 - 1 - 5 4.6 14.2

Wholesale Trade

5000-

5199

- - 1 1 1 1 - - - 4 3.7 17.0

Retail Trade

5200-

5999

2 1 1 1 - 1 1 2 - 9 8.3 32.4

Finance, Insurance, and

Real Estate

6000-

6999

1 1 1 2 2 - - 1 - 8 7.3 20.9

Services

7000-

8999

1 2 4 6 2 - - 1 1 17 15.6 25.8

Hotels, Rooming Houses,

Camps and Other

7000-

7099

- - 1 1 - - - - - 2 1.8 20.6

Personal and Business

Services

7200-

7399

- 1 - 4 2 - - - - 7 6.4 21.5

Motion Pictures

7800-

7899

- - - 1 - - - - - 1 0.9 40.3

Health Services

8000-

8099

1 1 3 - - - - - 1 6 5.5 31.2

Engineering, Accounting,

& Related Services

8700-

8799

- - - - - - - 1 - 1 0.9 20.2

Total Firms (N)

5 8 14 32 21 11 4 11 3 109

Percentage of Total Firms

4.6 7.3 12.8 29.4 19.3 10.1 3.7 10.1 2.8 100

Implied Probability of

Bankruptcy δ , %

23.1 22.6 32.9 23.5 23.7 21.7 22.4 23.5 25.2 24.5 24.5

36

Table 3

Estimated Probability of Bankruptcy

Panel A: Descriptive Statistics for Implied Probability of Bankruptcy δ

This panel contains the minimum, maximum, quartiles, means, standard deviations, and ranges for the implied

probability of bankruptcy δ for sample firms. The implied probability of bankruptcy δ is estimated over the period

1998 to 2006 for distressed firms and June through July 2006 for S&P 500 firms, respectively.

Distressed

Firms

S&P 500

Firms

Minimum 1.49 % 0.48 %

Quartile 1 12.64 % 1.20 %

Median 20.51 % 1.65 %

Quartile 3 33.67 % 2.45 %

Maximum 69.46 % 8.19 %

Mean 24.49 % 1.92 %

Standard deviation 16.38 % 1.09 %

Range 67.97 % 7.71 %

N 109 362

Panel B: Tests of Differences in Probability of Bankruptcy δ

This panel presents univariate tests of differences in mean and median values between distressed firms and S&P 500

firms for the probability of bankruptcy δ. The t-statistic provides a test of the null hypothesis that the mean values of

the probability of bankruptcy do not differ between the two groups. The Wilcoxon sign-rank Z-statistic provides a

test of the null hypothesis that the median values do not differ. Significance levels are indicated as follows: ***1%,

**5%, *10%.

Distressed Firms S&P 500

Firms

Mean

[Median]

Mean

[Median]

t-statistic

(p-value)

Wilcoxon

Sign rank

Z-statistic

(p-value)

24.49

[20.51]

1.92

[1.65]

14.37 ***

(<0.0001)

15.47 ***

(<0.0001)

37

Table 4

Comparison of Implied Probability of Bankruptcy δ with Other Measures of Firm Risk

Panel A: Comparison of Implied Probability of Bankruptcy δ with Debt Ratings

This panel compares the mean implied probability of bankruptcy (δ) for sample firms versus S&P 500 firms sorted

according to the senior long-term debt credit rating. The δ for distressed firms is measured over the period described

in Table 1. The δ for S&P 500 firms is estimated over the period June through July 2006. The historical S&P global

average one-year default rate is also listed for comparison purposes.

Distressed Firms S&P 500 Firms S&P Long-Term

Senior Debt Rating

(or Moodys

Equivalent)

Mean δ N Mean δ N

S&P Global

Average One-

Year Default

Rate

a

AAA to AA -- -- 1.58 % 25 0.01 %

A 4.36 % 1 1.60 % 124 0.04 %

BBB 18.90 % 5 1.86 % 132 0.29 %

BB 25.06 % 12 2.84 % 33 1.20 %

B 22.04 % 35 3.15 % 7 5.71 %

CCC 27.79 % 16 -- -- 28.83 %

b

Below CCC 30.54 % 5 -- -- --

N 109 362

a

Source: S&P Quarterly Default Update & Rating Transitions, April 2005. Average default rate is for the period

1981 to 2004.

b

Value includes firms rated CCC and lower.

Panel B: Comparison of Implied Probability of Bankruptcy δ with Other Risk Measures for Distressed Firms

This panel lists mean values for the implied probability of bankruptcy δ and other measures of firm risk for the

sample of distressed firms. Firms are grouped into four quartiles based on the implied probability of bankruptcy δ.

Only firms in which the δ is estimated within one year of Chapter 11 filing are included. Z-scores are included if

available within one year of the bankruptcy filing date.

Mean δ Total Assets

($ Millions)

z-score S&P Senior LT

Debt Rating

a

S&P Equity

Rating

b

Quartile 1 8.51 % 6236.6 0.402 16.2 18.3

Quartile 2 16.07 % 12,634.5 0.051 17.7 19.2

Quartile 3 25.28 % 7526.6 -0.181 17.5 18.6

Quartile 4 48.71 % 4230.1 -0.304 17.8 19.6

N 89 89 39 72 46

a

The S&P senior long-term debt rating has been converted to the numerical code that Compustat uses, as follows:

2=AAA, 4=AA+, 5=AA, 6=AA, 7=A+, 8=A, 9=A-, 10=BBB+, 11=BBB, 12=BBB-, 13=BB+, 14=BB, 15=BB-,

16=B+, 17=B, 18=B-, 19=CCC, 20=CC, 21=C, 22=D.

b

The S&P equity rating obtained from Compustat follows a similar numerical scale. For example, 7=A+ (Highest),

16=B+ (Average0, 17=B (Below Average), 18=B- (Lower), 21=C (Lowest).

38

Panel C: Comparison of Implied Probability of Bankruptcy δ with Debt Ratings Changes

This panel reports the period in months (see column on right) that the implied probability of bankruptcy (δ) increase

preceded the debt rating change for the sample of distressed firms. Sample firms are selected whose credit rating

was available through Bloomberg. The δ, mean debt rating, and days to Chapter 11 is measured over the period

described in Table 1. The debt ratings are converted to numerical code as described in Panel B.

Distressed Firms

N Mean δ Mean Debt

Rating

Mean Days

to Ch.11

Period δ

Precedes Debt

Rating Change

Firms with credit rating

BB or higher

8

31.17 % 12.8 223.5

Two to six

months

Firms with credit rating

B or CCC

36

31.12 % 17.9 214.5

One to three

months

Firms with credit rating

CC or lower

3

42.38 % 24.3 149.7

Less than one

month

All above firms 47 32.04 % 17.2 214.9 Up to six months

39

Table 5

Implied Probability of Bankruptcy (δ) for Firms Impacted by the Subprime Mortgage Crisis

This table presents analysis on 9 construction and business services firms impacted by the subprime mortgage crisis.

Analysis is conducted over January 2007 through May 2008.

Company

(Industry)

δ on Jan.

3, 2007

Maximum

δ and Date

Wall Street Journal News (Date)

CarMax

(Retailer)

7.31%

17.63%

(1/3/08)

Cut its earnings estimate for fiscal 2008, blaming housing slump and subprime-

mortgage crisis for slowing auto sales. (Sept. 19, 2007)

Centex (Building

Construction)

2.27%

30.43%

(4/2/08)

The company took $1 billion in third-quarter charges from significant effects of the

mortgage-market disruptions. (Oct. 12, 2007)

FedEx

(Transportation)

1.58%

8.31%

(4/16/08)

Firm will cut earnings estimate, blaming slowing economy; says "freight business

has been impacted by the slowing economy, especially the housing market." (Sept.

20, 2007)

General Electric

(Conglomerate)

0.00%

5.44%

(4/14/08)

Expects a $300-$300 million loss related to its planned exit from the subprime

market, third time in as many quarters that GE's results will be affected by subprime

woes. (Sept. 18, 2007)

KB Home

(Building

Construction)

7.17%

24.61%

(3/24/08)

Year-over-year revenue dropped 32%. Oversupply of unsold new and resale homes

and downward pressure on new home values has worsened in many of our markets

as tighter lending standards and related factors suppress demand. (Sept. 27, 2007)

Lennar (Building

Construction)

3.2%

28.95%

(2/8/08)

Swung to loss, cut 35% of work force. (Aug. 6, 2007)

Lowe's (Retail

Trade)

2.66%

9.03%

(3/31/08)

Expects EPS at low end of an earlier forecast; blames a weaker housing market than

most predicted, a subprime credit situation that was deeper than most realized, and

deflation in lumber and plywood. (Sept. 26, 2007)

McGraw Hill

(Publishing,

Business

Services for

S&P Subsidiary)

0.50%

22.66%

(11/14/07)

Representative Barney Frank announces plans to hold hearings in the House

Financial Services Committee investigating credit rating agencies role in the

subprime mortgage crisis. (Aug. 15, 2007)

PMI Group

(Mortgage

Insurer)

0.00%

53.67%

(3/19/08)

Expects to report a third-quarter loss of about $1.05 a share. (Oct. 19, 2007)

Average 2.74% 22.30%

40

Table 6

Implied Probability of Bankruptcy (δ) for All Financial Firms with Traded Stock Options

This table presents the average, median, and maximum implied probability of bankruptcy δ for all financial firm

groups over the period January 2007 through May 2008.

Average (δ) Median (δ) Max (δ)

Financial Universe 3.71% 3.95% 9.69%

Money Center Banks 2.18% 2.30% 13.33%

Regional - Northeast Banks 1.83% 1.12% 6.93%

Regional - Mid-Atlantic Banks 1.31% 0.25% 32.81%

Regional - Southeast Banks 1.80% 0.79% 11.00%

Regional - Midwest Banks 1.65% 1.13% 7.25%

Regional - Southwest Banks 1.40% 1.12% 10.23%

Regional - Pacific Banks 2.97% 1.72% 10.87%

Foreign Money Center Banks 2.34% 1.92% 9.60%

Foreign Regional Banks 3.56% 2.83% 10.54%

Savings & Loans 4.23% 4.37% 18.18%

Investment Brokerage - National 5.49% 5.95% 16.27%

Investment Brokerage - Regional 5.74% 5.55% 15.77%

Credit Services 5.60% 5.92% 15.87%

41

Table 7

Implied Probability of Bankruptcy (δ) for All Money Center Banks

This table presents the average, median, maximum and date of the maximum implied probability of bankruptcy δ for

all money center banks over the period January 2007 through May 2008.

Pane A: Money Center Banks

Ticker Company Name Average (δ) Median (δ) Max (δ) Date Max

δ obtained

BAC BANKAMERICA CORP 1.54% 0.10% 10.14% 3/17/2008

BK BANK OF NEW YORK MELLON

CORP

1.90% 0.00% 11.04% 11/16/2007

C CITIGROUP INC 2.04% 0.00% 20.45% 3/20/2008

FDC FIRST DATA CORP 4.42% 1.51% 100.00% 8/16/2007

JPM J P MORGAN CHASE & CO 3.20% 2.94% 17.68% 3/17/2008

KEY KEYCORP NEW 1.29% 0.00% 13.83% 3/18/2008

MEL MELLON BANK CORP 0.02% 0.00% 1.40% 6/22/2007

OFG ORIENTAL FINANCIAL GROUP 2.35% 0.00% 74.70% 10/15/2007

PNC PNC BANK CORP 1.37% 0.06% 8.57% 2/5/2008

RY ROYAL BK CDA MONTREAL

QUE

1.00% 0.00% 7.01% 3/6/2008

STI SUNTRUST BKS INC 1.32% 0.00% 11.76% 3/20/2008

TCB TCF FINL CORP 2.76% 0.50% 22.32% 2/1/2007

TD TORONTO DOMINION BK ONT 0.53% 0.00% 6.60% 1/14/2008

WB WACHOVIA CORP NEW 8.16% 0.79% 100.00% 9/25/2007

WFC WELLS FARGO & CO 0.82% 0.00% 14.33% 3/20/2008

Panel B: Foreign Money Center Banks

Ticker Company Name Country Average (δ) Median (δ) Max (δ) Date Max

δ obtained

ABN ABN AMRO HLDG

NV

Netherlands 1.50% 0.01% 12.97% 3/26/2008

CS CREDIT SUISSE

GROUP

Switzerland 0.94% 0.00% 8.92% 1/8/2008

DB DEUTSCHE BANK

AG

Germany 1.31% 0.52% 9.17% 4/2/2008

IBN ICICI BK LTD India 2.84% 2.20% 12.74% 11/23/2007

ITU BANCO ITAU HLDG

FINANCIERA S

Brazil 2.98% 2.41% 11.73% 3/20/2008

MTU MITSUBISHI UFJ

FINL GROUP IN

Japan 2.94% 0.97% 28.20% 11/13/2007

UBB UNIBANCO-UNIAO

DE BANCOS BRA

Brazil 3.22% 2.91% 11.70% 2/21/2008

UBS UBS AG Switzerland 2.99% 1.34% 35.38% 3/20/2008

42

Table 8

Implied Probability of Bankruptcy (δ) for All Foreign Regional Banks

This table presents the average, median, maximum and date of the maximum implied probability of bankruptcy δ for

all foreign regional banks over the period January 2007 through May 2008.

Ticker Company Name Country Average (δ) Median (δ) Max (δ) Date

Max δ obtained

BBD BANCO

BRADESCO

Brazil 6.29% 0.17% 52.82% 5/27/2008

BBV BANCO BILBAO

VIZCAYA

ARGENTA

Spain 0.99% 0.00% 17.85% 1/19/2007

BPOP Banco Popular Puerto

Rico

1.63% 0.00% 11.07% 3/31/2008

CIB BANCOLOMBIA Colombia 1.60% 1.33% 9.24% 1/18/2007

FBP FIRST BANCORP Puerto

Rico

1.89% 0.00% 16.02% 3/15/2007

HDB HDFC BANK LTD India 4.09% 3.38% 11.82% 1/16/2008

KB KOOKMIN BK South

Korea

2.71% 2.46% 13.61% 9/17/2007

RGF R & G FINANCIAL

CORP

Puerto

Rico

9.26% 9.89% 15.96% 2/16/2007

43

Table 9

Implied Probability of Bankruptcy (δ) for Brokerage Firms

This table presents the average, median, maximum and date of the maximum implied probability of bankruptcy δ for

all brokerage firms examined over the period January 2007 through May 2008.

Panel A: National Brokerage Firms

Ticker Company Name Average (δ) Median (δ) Max (δ) Date Max δ obtained

AMTD TD AMERITRADE HLDG

CORP

8.88% 4.69% 53.58% 8/16/2007

BSC BEAR STEARNS COS INC 5.19% 3.78% 30.64% 3/12/2008

COWN COWEN GROUP INC 8.78% 1.27% 100.00% 3/7/2008

ETFC E TRADE FINANCIAL CORP 6.87% 3.96% 39.59% 3/20/2008

GS GOLDMAN SACHS GROUP

INC

4.19% 4.03% 15.88% 3/17/2008

IBKR INTERACTIVE BROKERS

GROUP IN

6.33% 0.00% 34.23% 5/1/2008

LEH LEHMAN BROS HLDGS INC 6.70% 5.70% 35.93% 3/27/2008

MER MERRILL LYNCH & CO INC 4.58% 3.43% 35.71% 3/19/2008

MS MORGAN STANLEY 9.35% 6.73% 100.00% 10/10/2007

NMR NOMURA HLDGS INC 1.65% 0.50% 18.68% 12/5/2007

OXPS OPTIONSXPRESS HLDGS

INC

3.04% 2.38% 17.57% 3/17/2008

SCHW SCHWAB CHARLES CORP

NEW

2.82% 2.09% 15.27% 3/18/2008

SEIC SEI CORP 3.65% 2.83% 25.90% 3/18/2008

TRAD TRADESTATION GROUP INC 4.86% 4.43% 17.12% 2/29/2008

Panel B: Regional Brokerage Firms

Ticker Company Name Average (δ) Median (δ) Max (δ) Date Max δ obtained

AGE EDWARDS AG INC 1.18% 1.51% 4.14% 9/28/2007

BLK BLACKROCK INC 2.29% 1.82% 11.08% 4/14/2008

FBR FRIEDMN BILLINGS RMSY 7.13% 1.38% 44.65% 5/27/2008

GFIG GFI GROUP INC 6.48% 5.92% 26.67% 3/18/2008

ITG INVESTMENT

TECHNOLOGY GP INC

3.79% 3.61% 13.61% 3/17/2008

JEF JEFFERIES GROUP INC 2.18% 0.74% 12.59% 4/7/2008

LAB LABRANCHE & CO INC 5.30% 0.86% 100.00% 10/23/2007

LM LEGG MASON INC 2.55% 1.43% 16.66% 5/22/2008

NITE KNIGHT CAPITAL GROUP

INC

5.01% 4.37% 13.22% 3/20/2008

RJF RAYMOND JAMES

FINANCIAL INC

3.22% 1.33% 30.25% 11/12/2007

SF STIFEL FINL CORP 12.90% 0.00% 100.00% 7/16/2007

SWS SOUTHWEST SECURITIES

GROUP

2.60% 0.00% 23.85% 5/12/2008

USO UNITED STATES OIL FUND

LP

24.85% 25.25% 100.00% 10/11/2007

WDR WADDELL & REED FINL

INC

0.86% 0.00% 18.02% 8/13/2007

44

Table 10

Implied Probability of Bankruptcy (δ) for All Credit Services Firms

This table presents the average, median, maximum and date of the maximum implied probability of bankruptcy δ for

all credit services firms examined over the period January 2007 through May 2008.

Ticker Company Name Average (δ) Median (δ) Max (δ) Date Max δ obtained

AACC ASSET ACCEP CAP CORP 7.29% 5.05% 38.47% 7/17/2007

ACF AMERICREDIT CORP 11.41% 9.40% 67.90% 1/29/2008

ADS ALLIANCE DATA SYSTEMS

CORP

4.50% 2.85% 28.56% 1/24/2008

ADVNB ADVANTA CORP 1.54% 0.00% 21.41% 5/2/2008

AEA ADVANCE AMER CASH

ADVANCE CT

3.04% 0.69% 22.41% 4/15/2008

AXP AMERICAN EXPRESS CO 8.01% 5.48% 100.00% 10/12/2007

CCRT COMPUCREDIT CORP 12.00% 9.68% 52.67% 1/16/2008

CIT CIT GROUP INC 5.12% 1.36% 27.59% 4/16/2008

COF CAPITAL ONE FINL CORP 7.12% 5.72% 21.64% 3/17/2008

CSE CAPITALSOURCE INC 3.57% 0.00% 32.90% 4/9/2008

CSH CASH AMER INTL INC 4.01% 2.62% 18.51% 5/30/2008

EFX EQUIFAX INC 1.54% 0.14% 11.22% 1/8/2008

EZPW EZCORP INC 7.91% 7.72% 22.77% 2/20/2008

FCFS FIRST CASH FINL SVCS

INC

7.82% 0.98% 66.53% 3/18/2008

FMD FIRST MARBLEHEAD CORP 5.70% 3.54% 33.77% 3/3/2008

FNM FEDERAL NATL MTG ASSN 4.57% 1.64% 45.68% 3/18/2008

MCO MOODYS CORP 7.57% 6.67% 28.71% 5/19/2008

NNI NELNET INC 3.44% 1.95% 19.41% 5/2/2008

PHH PHH CORP 2.65% 1.42% 23.39% 2/6/2008

SFI STARWOOD FINANCIAL

INC

3.52% 0.00% 31.85% 4/10/2008

SLM SLM CORP 7.43% 6.53% 37.59% 3/24/2008

TAXI MEDALLION FINL CORP 0.75% 0.00% 11.62% 5/23/2008

WRLD WORLD ACCEP CORP DEL 8.21% 7.85% 18.34% 4/17/2008

45

Figure 1

Implied Probability of Bankruptcy for Dana Corporation

(Chapter 11 Bankruptcy filed 3/3/06)

0%

5%

10%

15%

20%

25%

30%

35%

1

/

3

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P

r

o

b

a

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i

l

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y

o

f

B

a

n

k

r

u

p

t

c

y

(

D

e

l

t

a

)

46

Figure 2

Implied Probability of Bankruptcy for Enron

(Note: Enron filed Chapter 11 on December 2, 2001)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

1

/

7

/

1

9

9

9

2

/

7

/

1

9

9

9

3

/

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9

9

9

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9

9

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/

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9

9

9

6

/

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/

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9

9

9

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/

7

/

1

9

9

9

8

/

7

/

1

9

9

9

9

/

7

/

1

9

9

9

1

0

/

7

/

1

9

9

9

1

1

/

7

/

1

9

9

9

1

2

/

7

/

1

9

9

9

1

/

7

/

2

0

0

0

2

/

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/

2

0

0

0

3

/

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/

2

0

0

0

4

/

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/

2

0

0

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5

/

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2

0

0

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6

/

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2

0

0

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/

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0

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0

8

/

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0

0

0

9

/

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/

2

0

0

0

1

0

/

7

/

2

0

0

0

1

1

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7

/

2

0

0

0

1

2

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1

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3

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0

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a

n

k

r

u

p

t

c

y

(

D

e

l

t

a

)

Implied Bankruptcy probability of 14.2% on October 15, 2001, the day before

Enron announces $544 Million after tax charge and $1.2 billion equity reduction.

November 19, 2001. Enron files its quarterly 10Q; also restated 1999 and

2000 net income retroactiverly. SEC requested information on LJM2.

47

Figure 3

Average Implied Probability of Bankruptcy for Building Construction Firms

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

1

/

3

/

2

0

0

7

2

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48

Figure 4

Average Implied Probability of Bankruptcy for Global Financial Firms with Traded Stock Options

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008

49

Figure 5

Average Implied Probability of Bankruptcy for Global Money Center Banks

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008

Money Center Banks Foreign Money Center Banks

50

Figure 6

Average Implied Probability of Bankruptcy for All US Regional Banks

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008

Regional - Northeast Banks Regional - Mid-Atlantic Banks Regional - Southeast Banks

Regional - Midwest Banks Regional - Southwest Banks Regional - Pacific Banks

51

Figure 7

Average Implied Probability of Bankruptcy for All Foreign Center Banks and Foreign Regional Banks

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008

Foreign Money Center Banks Foreign Regional Banks

52

Figure 8

Average Implied Probability of Bankruptcy for All National and Regional Brokerage Firms

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008

Investment Brokerage - National Investment Brokerage - Regional

53

Figure 9

Average Implied Probability of Bankruptcy for All Credit Services Firms

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008

1

Introduction

Corporate bankruptcy is central to the theory of the ﬁrm. As pointed out by Jensen and

Meckling (1976) “the legal deﬁnition of bankruptcy is diﬃcult to specify precisely. In general, it occurs when the ﬁrm cannot meet a current payment on a debt obligation...In this event the stockholders have lost all claims on the ﬁrm, and the remaining loss, the diﬀerence between the face value of the ﬁxed claims and the market value of the ﬁrm, is borne by the debtholders”. This is the deﬁnition of bankruptcy that we adopt in this paper. Probability of bankruptcy is the likelihood that stockholders will walk away with nothing and the stock will lose all its value. This paper aims to achieve several goals by presenting both theory and empirical evidence on a contemporaneous method for estimating the implied probability of bankruptcy. We present a modiﬁcation of the Merton’s (1976) ruin model and derive closed-form solutions for the price of options written on individual stocks. Our option pricing equations depend on the probability of bankruptcy, the volatility of the stock, and the other observables that aﬀect the Black-Scholes model. Since bankruptcy probability is not an observable variable, calls and puts can be inverted to yield simultaneously the implied probability of bankruptcy and the implied volatility as functions of the stock price, the stock option price, and other observables. We empirically test our model on two crucial samples. First, we examine all major ﬁrms that ﬁled for Chapter 11 bankruptcy protection in which options were traded over the period 1998-2006. The model predicts well for this group: the mean implied bankruptcy probability for Chapter 11 ﬁrms is 24.5 percent versus 1.9 percent for Standard and Poors 500 ﬁrms. The diﬀerence in means of the bankruptcy probabilities is signiﬁcant at the one percent level. Our results are robust across industries and years of the sample period. Furthermore, the implied probability of bankruptcy is generally consistent with z-scores, senior long-term debt ratings, and common stock ratings for sample ﬁrms. Second, we test our model on ﬁrms impacted by the subprime crisis. The subprime crisis, 2

Electronic copy available at: http://ssrn.com/abstract=773844

which began in the U.S., has had profound eﬀects globally. Our analysis of this crisis provides new evidence on the ﬁnancial interlinkages for bankruptcy risk of global banking institutions and nonﬁnancial ﬁrms. Speciﬁcally, we analyze the universe of all ﬁnancial ﬁrms and selected building construction and credit services ﬁrms with traded stock options, and the results are striking. We ﬁnd that the average probability of bankruptcy for the whole ﬁnancial ﬁrms universe increases from 1 percent to 7 percent while the default probability for the building construction ﬁrms increases from 1 to 15 percent. A few noteworthy examples are as follows: the bankruptcy probability for Bear Stearns reaches 30 percent on March 12, 2008; Fannie Mae’s bankruptcy probability reaches 46 percent on March 18, 2008; and Countrywide Financial’s bankruptcy probability hits 84.5 percent on November 20, 2007, less than two months before they were rescued through acquisition by Bank of America. Our results illustrate the two types of channels for international transmission of the subprime crisis: common shocks (a concurrent impact such as experienced by money center banks globally) and spillover eﬀects (a delayed impact, which our results show as of May 2008 is still unfolding for regional banks both in the U.S. and globally). The spillover eﬀect can be observed for Banco Bradesco (Brasil) with default probability of 52.82% computed on May 27, 2008. It could also be noted that for 15 out of 23 credit services ﬁrms, the maximum value of the default probability is achieved after March 2008 and at the end of May 2008 there is still a noticeable upward trend in the average default probability for that group. Our bankruptcy risk is the ex-ante subjective bankruptcy probability embedded by the market about the likelihood that shareholders will lose all their investment in the stock during the life of the option. Recent ﬁnancial scandals (e.g. Enron) reported by the ﬁnancial press suggest that for some ﬁrms this ex-ante probability might be diﬀerent from zero and worth considering by an option pricing model. For example, according to a ﬁling with the SEC in June 2003, the communications provider Genuity reports that the ﬁrm “believes that its stockholders will not receive any proceeds from the liquidation and that its common stock will have no value in connection with the liquida-

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tion”. In November, “Genuity said that the [bankruptcy liquidation] plan speciﬁes payments that are to be made to the company’s creditors. Stockholders will not receive any distribution under the liquidation plan”.1 Other U.S. companies that went bankrupt where stockholders lost all their investment include Williams Communications, Cray Computer, B&M, Continental, Mortgages GAC, and others. We examine many of these ﬁrms in our paper. Also, in agreement with these facts, our study answers research calls, among others, by Leland (1994, p. 1221) who writes that “stock option pricing models ...need to reﬂect...the possibility that the value of equity reaches zero with positive probability”. Bankruptcy probabilities implied by stock and stock option prices can yield valuable insights for at least three contexts: bankruptcy reorganization and liquidation, ﬁnancial distress and capital structure, and risk management. Smith and Stultz (1985) have shown that ﬁrms facing bankruptcy risk should hedge, and Brown and Toft (2002) derive the optimal hedging strategy for ﬁrms that face bankruptcy and other deadweight costs. Hence, our paper also shares with a line of research, represented by Altman (1968) and Altman, Haldeman, and Narayanan (1977), the recognition that it is important to predict the possibility of bankruptcy.2 These authors developed econometric models that use accounting ratios and market-driven ratios to explain bankruptcy. Another relevant strand of literature looks at equity as a barrier option on the assets of the ﬁrm, where bankruptcy is triggered by the barrier (see Toft and Prucyk, 1997, and Brockman and Turtle, 2003).

1 2 3

3

In our paper, instead of modeling the ﬁrm value, we take the stock price process as

Web Host Industry Review, http://thewhir.com/marketwatch/gen061203.cfm and gen112803.cfm. See Altman (1993) for comprehensive reviews of this line of research. Toft and Prucyk (1997) value a call option written on equity as a compound down-and-out barrier option, where

the equity process is given by the diﬀerence between the asset and the bond processes of the ﬁrm. Brockman and Turtle (2003) value equity as a down-and-out call option written on the assets of the ﬁrm where the strike price is the promised future debt payment required on the bonds issued by the ﬁrm. Their closed-form valuation equations depend on the value of the assets of the ﬁrm, ﬁrm volatility, bond parameters, the bankruptcy trigger which is linked to ﬁrm and bond values, and other usual parameters.

4

exogenous. Hence our paper distinguishes from these works, since we propose the use of individual stocks and options on individual stocks to obtain information on ﬁnancial distress. Neither the value of the ﬁrm nor the value of the bonds directly aﬀect our models.

4

In general, it is not appropriate to assume that it is possible to construct and to maintain a continuously dynamic hedging portfolio for distressed ﬁrms and ﬁrms that have ﬁled for bankruptcy. Hence, instead of the hedging arguments used by Black and Scholes (1973) to derive option prices, we use equilibrium arguments similar to those of Rubinstein (1976), Brennan (1979), Stapleton and Subrahmanyam (1984), Amin and Ng (1993), and Camara (2003) to obtain pricing formulae.5 In the actual world or under the actual probability measure the stock price depends on the probability of bankruptcy, a location parameter, and a scale parameter. Then using simple relations in equilibrium, we eliminate from the option pricing equations not only preferences and the location parameter, but also the scale parameter. These are substituted by the risk free rate of return and the stock volatility, parameters which do not aﬀect the process of the stock under the actual probability measure. The probability of bankruptcy does not change from the actual to the risk-neutral world. Overall, our model and empirical evidence illustrate potential applications of this new valuable measure of bankruptcy risk. To present our model and ﬁndings, we proceed as follows. Section 2 presents the assumptions underlying our theory. Section 3 derives preference-dependent pricing equations. Section 4 obtains preference-free option pricing equations. Section 5 provides the empirical tests of the model for ﬁrms that ﬁle Chapter 11 bankruptcy protection and global ﬁrms impacted by subprime crisis. Section 6 concludes.

4

Cremers, Driessen, Maenhout, and Weinbaum (2004) and Carr and Wu (2006) use stock options as information

**sources for credit default swaps.
**

5

Schroder (2004) derives general conditions for this equilibrium option pricing approach.

5

. and F0 is the information set available to the investor at date t = 0.t .. ρ is the time discount factor. t). to the best of our knowledge. These are the random shocks to consumption c. Ut (Ct ) is the utility function of consumption at date t.) that mature at date T . Assumption 1 (Representative agent) There is a representative agent who maximizes: T E t=0 Ut (Ct ) | F0 . τ 6 .2 The economic framework This section starts by presenting our assumptions on preferences and processes for consumption and the stock price.t and to the stock price s.τ ). Then..T ) = U (CT ) U (C0 ) CT C0 −b = ρT .T (C0. The uncertainty in this economy is driven by the realization of two random variables at each discrete date. . The option pricing formulae derived in this article is based on four assumptions. we use this assumption to derive the stock-speciﬁc pricing kernel. This paper derives prices for options at dates t (t = 0. E is the expectations operator. b is the coeﬃcient of proportional risk aversion. The information set of the investor at date t is = 0. Assumption 1 implies that. represented by the σ−algebra Ft ≡ σ(( c. at t = 0. (2) There is only one pricing kernel in the economy.. 1. was not done previously in modern ﬁnance theory.τ . which is implicit in the valuation of all assets and is dependent on aggregate consumption. the pricing kernel implicit in option prices that mature at T is given by the following equation: φ0. The assumption that the stock price follows a delta-geometric random walk. s. 2.. (1) where: 1−b Ut (Ct ) = ρtCt /(1 − b). 1. .

7 .t .t − 1 2 T 2 σs. in particular. has an expected or mean rate equal to µc T √ and a volatility or standard deviation equal to σc T . 7 The delta-lognormal distribution is due to Aitchison (1955).t ) | s. ln(S0) + t=1 µs. Then at the end of each period and.t − σs.t ) s. Assumption 3 (Stock price process) The stock price follows a delta-geometric random walk: St = where { s. between 0 and T . s.t .t .Assumption 2 (Consumption process) Aggregate consumption follows a geometric random walk: Ct = Ct−1 where { c.t .t .t 1 2 = 0] = µs.t is a sequence of independent non-negative random variables such that: (i) P( = 0) = δt . 2 (4) Aggregate consumption growth. (3) is a sequence of independent positive random variables having the same distribution6 c. t=1 T 2 σs. at date T the stock price ST has a deltalognormal distribution:7 T T ST ∼ ∆ 1 − t=1 6 (1 − δt ). σc T .t } c. stationary consumption is not a necessary condition to price options in discrete-time economies. in particular. 2 V ar[ln( s. it simpliﬁes the notation and focus the paper on the pricing of the options. t=1 (6) As remarked by Rubinstein (1976).t ) 2 | F0 ] = σc .t ) 2 | F0 ] = µc − 1 σc and V ar[ln( 2 c.t 2 = 0] = σs.t (ii) E[ln( | s. such that E[ln( Assumption 2 implies that at the end of each period and. at date T consumption CT is lognormally distributed: 1 2 2 CT ∼ Λ ln(C0 ) + µc T − σc T.t } 0 St−1 (5) s. However.

Z > 0. T T 2 σs.t is a location parameter (and not the expected return) of a delta-geometric random walk at t. while the probability of bankruptcy at a particular date t conditional on no earlier bankruptcy is δt . It should be underlined that while the assumptions involve the actual location and scale processes of the delta-geometric random walk.t is the scale parameter (and not the standard deviation) of a delta-geometric random walk at t.t t=1 s. are given by8 : E V ar ST | F0 S0 ST | F0 S0 T T = t=1 T (1 − δt )exp t=1 T µs.t t=1 t=1 t=1 T T The expected value and the variance of stock returns. 8 . and the actual location and scale parameters of the stock price.which means that: P (ST < 0) = 0. (8) = t=1 (1 − δt )exp t=1 2µs. considering the distribution of ST given by formula (6). In this sense σs. None of these parameters is stochastic. i. neither of these variables enters into the preference-free closed-form option pricing solutions derived in the sequel. t=1 T 1 T 2 T 2 (1 − δt ) + (1 − δt )Λ ln(S0 ) + µs.t − σ . The scale parameter 8 The moments of an actual delta-lognormal stochastic variable are given by Aitchison and Brown (1957. the stock speciﬁc pricing kernel depends on preference parameters. 95).t .t where µs.e. At this stage the location and the scale parameters can be eliminated. p.t − t=1 t=1 (7) exp (1 − δt ) . When we derive equilibrium prices for the stock and the options then there is no arbitrage and the call-put parity holds. The location parameter is eliminated from option prices when the fundamental equilibrium relation of the economy is used in these option prices to eliminate preference parameters. they are substituted by the risk-free rate and the stock volatility. The probability of bankruptcy up to date T is 1 − T t=1 (1 − δt ). 2 t=1 s. Initially. T P (ST = 0) = 1 − P (ST < Z) = 1 − (1 − δt ). in our economy. σ .

. are given by the following equations: ST | F0 S0 ST Kur | F0 S0 Ske where: T = = ¯ ¯ ω 3 − 3δω + 2δ 2 .. It should also have f1(ST )dST = 1. T 2 σs. . 2.. respectively. However. The normal random variable with mean and variance. t = 0. t=1 ω = exp The delta-lognormal distribution has no probability density function (pdf) in a rigorous sense. p. T. and f1 (ST ) is a dirac-delta function. ¯ ¯ δ 1/2(ω − δ)3/2 ¯ ¯ ¯ ω 6 − 4δω 3 + 6δ 2 ω − 3δ 3 . The skewness and the kurtosis of the distribution of ST /S0 . 1. 9 ∞ −∞ The dirac-delta function f1 (ST ) is suppose to be inﬁnite at ST = 0 and zero otherwise.9 Assumption 4 (Bond price process) There is a zero coupon bond with the following price process: Bt = e−r(T −t) . ¯ ¯ δ(ω − δ)2 (9) (10) ¯ δ = t=1 (1 − δt ). 9 . of 0 and σ2 converges to the dirac-delta function f1 (ST ) as σ → 0. (11) where r is the continuously compounded interest rate and T the maturity of the bond.is substituted in equilibrium by the stock volatility using the relations between the lognormal and the delta-lognormal. considering the distribution given by formula (6). the delta-lognormal has a “pseudo-pdf” given by: T T g(ST ) = 1 − t=1 (1 − δt ) f1 (ST ) + t=1 (1 − δt )f2 (ST ) where f2 (ST ) is a lognormal pdf.t . as pointed by Dennis and Patil (1988. The probability of bankruptcy is a parameter that does not change from the actual delta-lognormal cumulative distribution function to the risk-neutral delta-lognormal cumulative distribution function. 325).

Option prices in our equilibrium framework are expectations with respect to a bivariate distribution of consumption and stock value. 2 2 (12) Proofs for this and the subsequent formal results are available upon request.T (S0.τ .T (C0. .. This identity will be useful to simplify the stock-speciﬁc pricing kernel. First. t) is the σ-algebra generated by the consumption process.T ) = E ρT CT C0 −b | F0 ∨ FsT (13) 10 .. but does not depend on random consumption.e. The σ−subalgebra Fst ≡ σ( Fct ≡ σ( s. Lemma 2 (Stock-speciﬁc pricing kernel) The pricing kernel φ0..T ) conditional on F0 ∨ FsT is given by: φ0. t) is the σ-algebra generated by the stock price process. Then FsT contains Ft is the direct product of the σ-algebras Fst and Fct . τ = 0. Ft = Fst all the information about the shock to the stock price up to the expiration date of the option T .. The σ-algebra Fct .Based on assumptions 1.. . The goal of the next lemma is to reduce the dimensionality of this problem by making option prices as an expectation with respect to the univariate distribution of the individual stock. Lemma 1 expresses the interest rate as a function of preference-based parameters. 1. parameters of the consumption process. The stock-speciﬁc pricing kernel is a function of the random stock price. τ c.. i. Hence. The stock-speciﬁc pricing kernel will depend on preference parameters. and parameters of the stock price. 1. The next lemma obtains the stock-speciﬁc pricing kernel by conditioning the pricing kernel on the stock. and 4 we can write down the following lemma: Lemma 1 (Interest rate) The continuously compounded interest rate is given by: 1 r = − lnE ρT T CT −b | F0 C0 1 2 1 2 = −ln(ρ) + bµc − bσc − b2σc . 2.τ . the stock-speciﬁc pricing kernel is a function of this individual stock. The σ−subalgebra = 0. we deﬁne two σ-subalgebras of Ft.

(15) (16) The next lemma uses the stock price process given by assumption 3 and the stock-speciﬁc pricing kernel given by lemma 2 to derive closed-form solutions for the prices of the options. 3 Preference-dependent pricing models This section investigates the pricing of European call and put stock options that mature at date T and have a strike price K.t 1/2 T ln(S0) + t=1 µs. 11 . The prices of European call and put options. T (17) (18) Pp = 1− t=1 (1 − δt ) Ke−rT + t=1 (1 − δt ) Ke−rT N (−d2) − S0 G(F0)N (−d1). 2 t=1 T where R is the correlation between the normal variates underlying consumption and the stock price. are given by the following formulae: P c = E ρT P p = E ρT CT C0 CT C0 (ST − K)+ | F0 .T (S0.T ) ∼ Λ −rT − b2R2 σc T. The stock-speciﬁc pricing kernel (13) is positive and has a lognormal distribution: 1 2 2 φ0. considering assumption 1. Note that there are as many stock-speciﬁc pricing kernels in the economy as the number of individual stocks.t − 1 2 1 2 2 σs. (K − ST )+ | F0 .= exp √ bRσc T T 2 t=1 σs.t − ln(ST ) − b2 R2σc T − rT . The next section will use this stock-speciﬁc pricing kernel as a stochastic discount factor to price call and put options. 2 (14) implying that there are no arbitrage opportunities between the individual stock and derivatives written on this stock. b2R2 σc T . This stock-speciﬁc pricing kernel can only be used to discount that individual stock and derivatives written on that individual stock. Lemma 3 (Preference-dependent option prices) The prices of European call and put options with a strike price K and a maturity date T are given by the following formulae: T Pc = S0G(F0)N (d1) − t=1 T (1 − δt ) Ke−rT N (d2).

where: ln d1 = S0 Q(F0 ) K T t=1 T + 2 σs.t t=1 and N(.t t=1 1/2 1/2 T T G (F0 ) = exp −bRσc T Q (F0 ) = exp −bRσc T √ √ + t=1 T µs. Equations (17) and (18) are not preference-free option pricing equations since they depend on the preference parameter b. The more general result of this section. which is presented 12 .t − bRσc T T rT − t=1 ln (1 − δt ) = t=1 .t t=1 T 2 σs. (19) This underlying equilibrium relation holds for the stock. the parameter of the consumption process σc . The next section will use this underlying equilibrium relation in the price of the options to eliminate preference-based parameters from option prices and to derive preference-free option prices. and the correlation between the normal variates underlying consumption and the stock price R. This parity holds since there are no arbitrage opportunities in the economy.t − σ . 4 Preference-free option prices This section derives preference-free closed-form solutions for the pricing of European call and put options written on individual stocks. The result is obtained using the call-put parity. T 2 σs. The next lemma gives the equilibrium relation that supports the option prices given by equations (17) and (18).t . 1/2 2 σs.t d2 = d1 − t=1 .) is the cumulative distribution function of a standard normal random variable.t t=1 √ µs.t − rT + t=1 ln (1 − δt ) . 2 t=1 s.t T t=1 1/2 2 σs. 1 T 2 + µs. Lemma 4 (Underlying equilibrium relationship) The underlying equilibrium of the economy is given by: T T 1/2 2 σs.

They depend on the current stock price S0. the strike price K. for example. The preference-free option pricing equations are obtained when we use the underlying equilibrium given by equation (19) in the preference-dependent option pricing equations (17) and (18) to eliminate preference-parameters from these valuation equations. the interest rate r.) is the cumulative distribution function of a standard normal random variable. The ﬁrst corollary assumes that the volatility of the logarithm of stock returns follows a stationary process. when one is interested in obtaining a single implied volatility and a single implied probability of bankruptcy from stock and stock option market prices. assumes that the volatility of the logarithm of stock returns and the probability of bankruptcy follow nonstationary processes. The theorem provides the more fundamental and general results presented in this paper. T d2 = d1 − + t=1 ln (1 − δt ) . T −rT (20) (21) Pp = where: 1− t=1 (1 − δt ) Ke + t=1 (1 − δt ) Ke−rT N (−d2) − S0 N (−d1). The second corollary assumes that the volatility of the logarithm of stock returns and the probability of bankruptcy follow stationary processes. 13 . the time-to-maturity of the option T . This model is useful. Pricing equations (20) and (21) do not depend on preference parameters. Theorem (Option prices with nonstationary bankruptcy probability and nonstationary volatility) The prices of European call and put options with a strike price K and a maturity date T are given by the following formulae: T Pc = S0N (d1) − t=1 T (1 − δt ) Ke−rT N (d2).in the next theorem. N (. and σt is the volatility of the logarithm of stock returns at date t. Then we state two important special cases of this theorem as corollaries. but that the probability of bankruptcy follows a nonstationary process. ln d1 = S0 K + rT + T t=1 T 2 σt t=1 2 σt 1 2 T t=1 2 σt − 1 2 T t=1 ln(1 − δt ) + T t=1 ln (1 − δt ) 1/2 1/2 .

(ωr − 1)3/2 6¯ ¯ 3 ωr δ 3 − 4δωr + 6ωr − 3 . = = 3¯ ωr δ − 3ωr + 2 (23) (24) (25) (26) ST | F0 S0 . ln (S0) + rT − 1 T 2 3 σ − 2 t=1 t 2 T T T 2 σt + ln (1 − δt ) . t=1 T 2 σt . = e2rT (ωr − 1) . (ωr − 1)2 ¯ δ = (1 − δt ). (27) 14 . are given by: ST | F0 S0 ST V ar | F0 S0 ST Ske | F0 S0 E Kur where: T = erT . Note that neither the location parameter of the stock µs. considering the distribution given by formula (22).t aﬀect option prices. The preference-free delta-lognormal distribution implicit in option prices (20) and (21) can be written as: T ST ∼ ∆ 1 − t=1 (1 − δt ) . t=1 (22) It is easily veriﬁed that the ﬁrst four moments of stock returns.the probability of bankruptcy 1 − T t=1 (1 − δt ) and the volatility of the logarithm of stock returns σt . Corollary 1 (Call and put option prices with nonstationary bankruptcy probability and stationary volatility) The prices of European call and put options with a strike price K and a maturity date T are given by the following formulae: T Pc = S0N (d1) − t=1 (1 − δt ) Ke−rT N (d2). t=1 t=1 ln (1 − δt ) . t=1 ωr = exp The next corollary incorporates a nonstationary bankruptcy probability process in the BlackScholes (1973) valuation equations.t nor the scale parameter of the stock σs.

T T Pp = where: 1− t=1 (1 − δt ) Ke−rT + t=1 (1 − δt ) Ke−rT N (−d2) − S0 N (−d1). and the volatility of the logarithm of stock returns. The preference-free delta-lognormal distribution implicit in option prices (27) and (28) is given by: ST ∼ ∆ 1 − T 1 3 T (1 − δt ) . Corollary 1 shows that option prices depend on the current stock price. ln (1 − δt ) 1/2 d2 = d1 − σ T + t=1 2 ln (1 − δt ) . 15 . (28) ln d1 = S0 K + r + 1 σ2 T − 2 σ 2T + T T t=1 1 2 T t=1 ln(1 1/2 − δt ) . the probability of bankruptcy. ln (S0) + rT − σ 2 T − ln (1 − δt ) . (25). the time-to-maturity of the option.) is the cumulative distribution function of a standard normal random variable. N (. the interest rate. They are independent of the location parameter and the scale parameter of the stock. and (26). The scale parameter of the stock was substituted in equilibrium by the stock volatility. ωr = exp σ 2 T . (24). This implies that the risk-neutral lognormal implicit in the Black-Scholes valuation equations and the risk-neutral delta-lognormal implicit in the option pricing equations (27) and (28) have identical mean (23) and variance (24). but now δ and ωr are given by: T ¯ δ = t=1 (1 − δt ). the strike price. σ 2T + ln (1 − δt ) . Equations (23) and (24) do not depend on the probability of bankruptcy. 2 2 t=1 t=1 t=1 T (29) The ﬁrst four moments of ST /S0 implicit in the option valuation equations (27) and (28) are ¯ still given by equations (23). This provides intuition to the fact that σ is the well known volatility parameter or standard deviation of the logarithm of stock returns used in the Black-Scholes model. and σ is the volatility of the logarithm of stock returns.

but now δ and ωr are given by: ¯ δ = (1 − δ)T . ln S0 K (30) (31) 1 − (1 − δ)T Ke−rT + (1 − δ)T Ke−rT N (−d2) − S0 N (−d1). a single volatility parameter. The closed-form solutions for the pricing of options will depend only on observables. σ 2T + ln (1 − δ)T .) is the cumulative distribution function of a standard normal random variable. Equations (30) and (31) also lead to Merton’s (1976) ruin option pricing model. (24). and (26). ωr = exp σ 2 T . The preference-free delta-lognormal distribution implicit in option prices (30) and (31) is given by: 3 1 ST ∼ ∆ 1 − (1 − δ)T . The ruin option pricing model of Merton (1976) assumes that the stock price follows a jump–diﬀusion process with a jump size of 16 . and N (. Corollary 2 (Call and put option prices with stationary bankruptcy probability and stationary volatility) The prices of European call and put options with a strike price K and a maturity date T are given by the following formulae: Pc = S0 N (d1) − (1 − δ)T Ke−rT N (d2). When δ = 0 in equations (30) and (31) then the Black-Scholes (1973) model obtains. 2 (32) The ﬁrst four moments of ST /S0 implicit in the option valuation equations (30) and (31) are ¯ still given by equations (23). and a single bankruptcy probability parameter. √ 2 + ln (1 − δ)]1/2 T [σ 1/2 √ = d1 − σ 2 + ln (1 − δ) T. ln (S0 ) + rT − σ 2T − ln (1 − δ) 2 T . (25).The next corollary simpliﬁes the option pricing problem. Pp = where: d1 = d2 + r + 1 σ 2 T − ln(1 − δ)T /2 2 .

and λ is the mean number of jumps per unit of time. Our scale parameter σs in Mer- ton’s words is the instantaneous variance of the return. While in Corollary 2 the probability that the stock price goes to zero is δ. ln S0 K which depends on σs and λ rather than on σ and δ of Corollary 2. 1 − e−λT Ke−rT + Ke−(r+λ)T N (−d2) − S0N (−d1). ln S0 K Now deﬁne λ = −ln(1 − δ) or (1 − δ)T = e−λT . σs T √ = d 1 − σs T . d2. and rewrite: d1 = d2 2 + r − ln(1 − δ) + 1 σs T 2 √ . we have σs = σ 2 + ln(1 − δ). Substituting this relation into d1. dq the actual Poisson process with P rob(dq = 2 1) = λdt. in Merton’s ruin option pricing model the probability that the stock price goes to zero is λdt. σs T √ = d 1 − σs T . (30). conditional on the no occurrence of jumps. 2 We obtain Merton’s model from Corollary 2 in two steps. Hence our Corollary 2 is equivalent to Merton’s (1976) ruin option pricing model with a diﬀerent interpretation of parameters.-100 percent when the jump occurs: dS = (µs + λ)Sdt + σs SdW − Sdq. where dW is the actual standard Gauss-Wiener process. An inspection of the formulas shows that while Merton’s model allows one to recover the mean number of jumps per 17 . Merton’s ruin option pricing model depends on σs and λ rather than on σ and δ as in Corollary 2. Pp = where: d1 = d2 2 + r + λ + 1 σs T 2 √ . First. We substitute this equation into d1 and d2 of Corollary 2. and (31) yields the Merton’s ruin option pricing model: Pc = S0 N (d1) − Ke−(r+λ)T N (d2).

a provider of bankruptcy information on U. λ = −ln(1 − δ). ﬁrms that ﬁled for Chapter 11 bankruptcy protection and that have traded stock options during the period January 1998 through December 2006.S. we analyze all ﬁnancial ﬁrms. This makes it possible to examine the global impact of the subprime crisis from a bankruptcy perspective. selected building construction ﬁrms and business services companies that have traded stock options. it seems unlikely that one could recover the probability of bankruptcy from market prices using Merton’s model without the relation that we establish in this paper between δ and λ. for example. In the next section. even if total assets are less than one billion dollars. equations (30) and (31) are going to be inverted to yield simultaneously the bankruptcy probability δ and the volatility σ as functions of the other variables. our model permits us to recover the probability of bankruptcy δ implicit in option market prices. We include all bankruptcies during this time period for ﬁrms with total assets greater than one billion dollars and also include the top 15 to 20 largest bankruptcies in each year.1 Empirical testing of the model Sample selection and data sources To empirically test the model. we use two diﬀerent data sets.10 5 5. we select ﬁrms where stockholders face substantial bankruptcy risk. 18 . However.unit of time λ from option prices. To accomplish this for our second data set. The results are the implied bankruptcy probability and implied volatility by option market prices. public and private ﬁrms. Information on the largest bankruptcies is obtained from the Bankruptcy Data Division of New Generation Research. One of our main empirical objectives is to analyze ﬁrms that were inﬂuenced by the subprime mortgage crisis. To construct the ﬁrst sample.S. This allows us to test the model on several bankruptcies 10 This can be implemented using. we investigate the largest U. First. a Newton-Raphson algorithm.

The rates are calculated using the continuously compounded zero-coupon interest rate derived from LIBOR rates and CME Eurodollar futures. 129 are US based and 16 are foreign based. Risk-free rates are obtained from Option Metrics. The pricing equations are inverted to yield implied values for the volatility and the bankruptcy probability. Among them. As part of this sample.Paciﬁc Banks. Investment Brokerage .Northeast Banks. Savings & Loans. Stock option data is obtained from Option Metrics. Foreign Money Center Banks. These are categorized into the following 12 industry groups: Money Center Banks. and Investment Brokerage . Regional . Regional .Regional and Credit Services. Regional . Table 1 provides a list of these distressed ﬁrms together with the Chapter 11 ﬁling date and other important information which is discussed in the following subsections. Options data for these ﬁrms was also obtained from Option Metrics. Regional Mid-Atlantic Banks. a market vendor of option data. Regional . We estimate values for these parameters by minimizing the sum of squared errors for each ﬁrm on each day. we subtract the present value of dividends from the stock prices. Regional . we ﬁnd that stock options were actively traded on 109 of these ﬁrms.Southwest Banks.National.Southeast Banks.2 Estimating the implied probability of bankruptcy The probability of bankruptcy δ is estimated from Equations 30 and 31. Where applicable.S.Midwest Banks. Many of the distressed ﬁrms have suspended dividends by the 19 . publicly-held ﬁrms that ﬁled Chapter 11 bankruptcy protection over the sample period. We restrict our analysis to options with maturities between two weeks and six months and exclude options that are far out-of-the-money. we also select various ﬁrms in the building construction and business services industries impacted by the subprime mortgage crisis to investigate the impact on selected nonﬁnancial ﬁrms. Foreign Regional Banks. 5. Of the 299 largest U. OptionMetrics has option and stock price information on 145 companies. 2007 and May 31.in each year of the sample period. 2008. The second universe consists of all ﬁnancial ﬁrms that have options traded with prices reported between January 1.

the estimate was statistically signiﬁcant. The table also lists the last date for which the bankruptcy probability can be estimated. it is not uncommon for deltas to change by several percentage points daily when examining this group of distressed ﬁrms. the number of days prior to bankruptcy ﬁling that the probability is estimated. It is also possible in such days that the optimization procedure produces either zero or one as an optimal result. The mean delta is estimated as the average value for the most recent six days in which data was available. In several cases we identiﬁed reported option prices that allowed arbitrage. and in which the optimization procedure converges. Note. The optimization procedure restricts volatility to non-negative values and the default probability between zero and one. The senior long-term debt rating is based on Standard and Poor’s (S&P) Long-Term Senior Issuer Credit (or Moodys if S&P is not available) and is obtained from Bloomberg on the exact date in which the last delta is estimated. Estimates for the implied probability of bankruptcy are statistically signiﬁcant at the 5 percent conﬁdence level.time of our analysis. that observation is dropped. we keep it in our analysis. and the ﬁrm’s total assets for the year preceding the bankruptcy ﬁling. For example. If the optimization does not converge on a given date. If the estimate is one. If the estimate is zero. However. 20 . 5. so default probability of one should not be interpreted as an ”imminent” bankruptcy but as an extreme increase in the potential future troubles for that ﬁrm. the senior long-term debt rating. 2008). Using the average delta over six trading days provides a better estimate than using the estimate for one day. that this estimate is an expected value. We eliminated these prices from our analysis. we report the average default probability of the last ﬁve days on that particular day.3 Analysis of ﬁrms that have ﬁled for Chapter 11 bankruptcy protection Table 1 presents the results for the implied probability of bankruptcy (delta) estimated for the sample of 109 distressed ﬁrms. for some ﬁrms during very turbulent periods the optimization procedure could not converge (for example Bear Stearns after March 12.

We calculate mean deltas for each of 21 .9 for Transportation by Air (SICs 4500-4599. 5 ﬁrms).5 percent. All ﬁrms in the S&P500 are selected on which options are actively traded during the period June through July 2006. it is clear that the results are not driven by one particular industry or bankruptcy year. the delta is 66.2 percent for Electric. At the time.5 percent). The largest yearly mean delta of 32. Interestingly. the S&P credit rating was B+ which indicates ”a greater vulnerability to default but currently has the capacity to meet interest payments and principal repayments”. The model is also useful to gauge ﬁrm risk in which debt ratings are unavailable.5 percent for the group. The mean delta is 24. respectively. On the whole. the delta for Mariner Post-Acute is estimated 325 days prior to bankruptcy ﬁling.4 percent 291 days before bankruptcy and debt ratings are not listed for this company. For industry groups with more than one ﬁrm.4 percent. Gas and Sanitary Services (SICs 4900-4999.2 percent. 7 ﬁrms) and the lowest is 14. Table 2 shows the delta calculated for distressed ﬁrms sorted according to industry group and year of bankruptcy ﬁling. debt ratings were obtained for 18 of the companies through Compustat for the month in which the last delta is estimated.5 and 25. For the remaining 35 ﬁrms. Given the high delta of 69. we choose ﬁrms in the Standard and Poors 500 (S&P500). the highest mean delta is 32. this implies that the model is useful in assessing the high probability of bankruptcy long before the Chapter 11 petition is actually ﬁled. For example. Debt ratings were not available for the remaining 17 ﬁrms. for Motient Corporation.7 percent occurs in 2003. It is useful to compare the model for a sample of healthy ﬁrms. The largest number of bankruptcies (32) for sample ﬁrms occurred in 2001 and the fewest bankruptcies (3) were in 2006. The mean deltas for these years are 23.9 percent occurs in 2000 and the lowest of 21. For this reason. The highest probability of bankruptcy is estimated for Mariner Post-Acute (69.5 percent) and the lowest probability of bankruptcy is estimated for Covanta Energy Corporation (1. Most bankruptcies (26 ﬁrms) occurred in the Communications Industry (SICs 4800-4899) with a mean delta of 25.Debt ratings were available for 74 of the ﬁrms through Bloomberg.

and the Altman z-scores. maximum. respectively. 2000. standard deviations. Z-scores are obtained from Compustat and are for the most recent year prior to bankruptcy ﬁling for distressed ﬁrms (or the closest year available) and for year-end 2005 for S&P500 ﬁrms. the S&P common stock rating. for Trans World Airlines (TWA). In order to determine how our implied probability of bankruptcy compares with other proxies for ﬁrm risk. the hypothesis of equal implied probabilities of bankruptcy is rejected at the one percent signiﬁcance level as both the mean and median values are signiﬁcantly higher for our sample of distressed ﬁrms. The z-score is an ordinal measure and has no direct probabilistic interpretation. The Wilcoxon sign-rank Z-statistic provides a test of the null hypothesis that the median values do not diﬀer. on January 10. the mean deltas (maximum deltas) are 24. The t-statistic provides a test of the null hypothesis that the mean values of the probability of bankruptcy do not diﬀer between the two groups.” It is interesting to note that approximately seven months later. we estimated that there is an implied probability of probability of 61. A key innovation of our model is that we can get a direct sense of the risk of the company by looking at the bankruptcy probability. means. Panel B presents univariate tests of diﬀerences in mean and median values for the deltas. TWA ﬁled Chapter 11.19) percent for distressed ﬁrms and S&P500 ﬁrms. we analyze the relation between delta and other measures such as the S&P debt rating. Likewise. Panel A of Table 3 summarizes the minimum.1 percent that the ﬁrm will go bankrupt within the next six months. none of the other measures provide a direct probabilistic interpretation of bankruptcy or default. quartiles.92 (8. we can make the following statement: ”As of June 28. and ranges for the probability of bankruptcy for the two sample groups: distressed ﬁrms and S&P500 ﬁrms. As shown in Panel B. As shown. For example. 2001.46) and 1. The S&P common stock rating is obtained from Compustat for the same month in which the last delta was estimated. Table 4 reports these results. Panel A compares the mean delta for distressed ﬁrms versus 22 .these 362 ﬁrms during this time frame.49 (69.

Dana Corporation. defaults and downgrades may be higher. Note that the global average default rate for ﬁrms rated CCC and below is similar to the delta estimated from our distressed ﬁrm sample (28. the delta increases monotonically consistent with the higher risk debt ratings for both groups.83 percent for S&P verses 27. the lowest delta is obtained for the ﬁrms with the highest quality debt rating for both groups and vice versa. we conduct additional analysis and present these results in Panel C. 23 . Interestingly. and S&P common stock rating for the sample of distressed ﬁrms. Firms are grouped into four quartiles based on the delta.79 and 30. Analysis is restricted to ﬁrms with deltas greater than 14 percent and whose credit rating is available through Bloomberg. over the period January 3. the quartile for the highest delta has the lowest mean ﬁrm size. To examine whether an increase of the probability of bankruptcy δ precedes the debt rating change for our sample ﬁrms. The S&P historical global average one-year default rate is also listed for comparison purposes. the z-score.54 percent for our distressed ﬁrms). S&P debt rating.S&P500 ﬁrms sorted according to the debt rating. the delta leads the debt rating change by the longest period (two to six months) for sample ﬁrms with ratings of BB or higher. Panel B lists mean values for delta. On January 3. We ﬁnd that delta increases implying a high probability of bankruptcy can lead the debt rating change by a period of up to six months. 2005. With the exception of distressed ﬁrms rated B. 2005 up until ten days before Chapter 11 bankruptcy was ﬁled. It is important to note that these are average default rates and that during periods of economic weakness. While there is not an overall trend for the relation between size and probability of bankruptcy. Figure 1 illustrates the delta for one of our sample ﬁrms. It appears that neither the S&P debt rating nor the S&P equity distinguishes as well as the delta and z-score for distressed ﬁrms. Only ﬁrms in which the delta is estimated within one year of Chapter 11 ﬁling are included. As shown. Zscores are not included in this panel if the value is not obtained within one year of the bankruptcy ﬁling date.

. One of our objectives is to identify how the subprime mortgage crises propagated around the world: from the United States 24 . that the company had not properly accounted for certain items during 2004 and the ﬁrst and second quarters of 2005. we conduct a global analysis of ﬁrms impacted by the subprime mortgage crisis. Perhaps one of the most famous unexpected bankruptcies in recent times is the December 2. On October 9. 2001 bankruptcy of Enron.4 Analysis of the subprime mortgage crisis and its replications around the world An important and highly useful application of the model is to analyze the impact of current events as they unfold. By mid-November. 5. the day before Enron announced adjustments to earnings and equity reductions. and concluded that Dana’s ﬁnancial statements for those periods should no longer be relied upon and should be restated. On October 10. the model captures the increased bankruptcy probability of the ﬁrm over time.the delta was ﬁve percent and by February 22. deferred tax assets. it had increased to 30 percent. Clearly. Over these two days. the implied delta was over 39 percent which demonstrates the model’s usefulness in capturing the increased bankruptcy risk of a ﬁrm. 2001. 2005. To test if the model captures important forward looking information about potential trouble with ﬁrms. we investigate both global ﬁnancial ﬁrms and nonﬁnancial ﬁrms (e. Dana’s management and Audit Committee determined. As shown.g. even a ﬁrm subject to fraud. as a result of ongoing internal investigations.2 percent on October 15th. Dana issued a news release reporting these items and also reported the write-oﬀ of its U. To do this. the delta value is estimated at 14. 2005. the delta increased to 29 percent.S. it provides additional information not available by most other models. U. 2006. building construction and business services ﬁrms) impacted by the subprime crisis. Because our model of risk uses contemporaneous data and does not rely on stale accounting information.S. Figure 2 illustrates the delta for Enron over the period January 1999 through December 2.

Figure 3 plots selected analysis from Table 5. 25 . While not included in Table 5 results.30 percent. As shown. we ﬁrst look at the building construction and business services industries. The diﬀerence in means is statistically signiﬁcant at the one percent level. The average delta on January 3. and globally).S. Table 5 lists the delta on January 3. 2007 and the maximum delta (including the date for this value) for the 9 ﬁrms analyzed. a mortgage insurer. additional analysis shows that our model anticipates increases in bankruptcy risk when debt ratings remain unchanged for this group of ﬁrms.11 Before discussing our results for the universe of ﬁnancial institutions analyzed. Table 5 and Figure 3 provide these results. mean deltas are less than two percent at the beginning of the year and remain less than ﬁve percent through mid-March.regional and center banks to foreign based center and regional banks. credit services and regional banking sectors. 2008. Results are illustrated over the period January 3 through May 31. Our analysis illustrates two primary channels for international transmission of the subprime crisis: ”common shocks” (a concurrent impact such as experienced by money center banks globally) and ”spillover” or ”contagion” eﬀects (a lagged impact such as experienced by the building construction.67 percent is obtained for PMI Group. on March 19. the delta for the home building industry increases dramatically reaching 15 percent 11 See Brown and Davis (2008) and Mason (2008) for additional discussion on the global impact and implications of the subprime crisis. A brief explanation as to how each ﬁrm is impacted by the subprime crisis is also provided in the table.74 percent whereas the average maximum delta is 22. These industries have experienced the ”spillover” eﬀect from the subprime crisis due to real sector demand declines and economic slowdown. 2008. Estimates are daily averages of the delta for building construction (primarily home builders). The highest maximum delta of 53. which our results show as of May 2008 is still unfolding for regional banks both in the U. concern over the subprime mortgage sector was at a lower level and had not reached the crisis levels of late summer. By late August 2007. During this period. 2007 is 2.

capturing the increased risk of bankruptcy in this market sector. savings and loans and the credit services ﬁrms are the most impacted by the subprime crisis.68 percent on May 23. For the whole universe the average bankruptcy probability is 3. 2008) one can observe a spike in the average default probability (from 6 to 9 percent). National and regional brokerages as well as credit services ﬁrms have averages higher than 5 percent. Since August 2007. There was no delay in the increase of the average default probability. Figure 5 plots the average bankruptcy probability for the US money center banks and foreign money center banks. Table 6 provides descriptive statistics for the entire ﬁnancial universe we study and for diﬀerent industry groups. The results demonstrate both the micro and macro aspects of these interlinkages for the subprime crisis globally. Note that there is an upward trend for the period January 2007 to May 2008. Moody’s. Around the Bear Stearns crisis (March 17.81 percent(Regional midatlantic banks).93 percent(Regional northeast banks) to 32. This results are consistent with the observed empirical evidence . 26 . Next.all fall in the above categories. It is clear that the foreign money center banks reacted simultaneously with the US money center banks around the Bear Sterns crisis. Speciﬁcally. Based on the average (median) bankruptcy probability. The range of the maximum values for δ is 6. Figure 4 shows the plot of the bankruptcy probability for all 145 ﬁnancial ﬁrms. South Financial Group (TSFG) has a dramatic increase in the default probability in May 2008 and at the same time. we analyze the ﬁnancial interlinkages of banking ﬁrms around the world. Panels A and B of Table 7 shows descriptive statistics for the individual ﬁrms from that category. Washington Mutual . the mean deltas have remained steadily high. has experienced a large drop in stock price from $20 per share to $3 per share. the highest average default probability is observed for the regional midatlantic banks. brokerage houses.and higher.71 percent with a maximum value of 9. Interestingly. This illustrates that ﬁnancial markets around the world have become fully integrated and information gets disseminated very fast. 2008.Bear Sterns.

Their default probability has recently picked up. the implied probability of bankruptcy for the credit services ﬁrms increased dramatically after that announcement. the increase in the default probability for the US regional brokers occurred with some delay relative to the increase in the US national brokers. In summary. It will be important to observe for how long this trend will continue. Overall. 2008. We believe this model makes 27 . Most likely in reaction to this news.Average bankruptcy probabilities for the US regional banks are graphed in Figures 6 and average bankruptcy probability for regional banks and foreign money center banks are graphed in Figure 7. The average bankruptcy probabilities for the US national and regional brokerage ﬁrms are illustrated in Figure 8. Moody’s delta had increased to a maximum level of 28. These results illustrate the ”spillover” or ”contagion” bankruptcy risk eﬀects due to the integrated nature of global ﬁnancial markets. note that there is a delay in the response of the bankruptcy probability. Figure 9 plots the average bankruptcy probability for the credit services ﬁrms. Representative Barney Frank announced plans to hold hearings in the House Financial Services Committee investigating credit rating agencies role in the subprime mortgage crisis. respectively. Panels A and B of Table 9 provide the descriptive statistics for the individual ﬁrms from these categories. the evidence in this section illustrates an important feature of our model: to analyze crisis situations as they evolve and to gauge bankruptcy risk using a forward-looking measure based on data from the option markets. 2007.71 percent. Table 8 shows descriptive statistics for the individual ﬁrms in the foreign regional banks category. We highlight the micro and macro aspects of international ﬁnancial integration due to the subprime crisis. In these two categories. Similar to the foreign ﬁrms category. On May 19. Table 10 shows descriptive statistics for the individual ﬁrms from that category. These results further highlight the ”spillover” eﬀects of the subprime crisis into the credit services industry. On August 15. the empirical results strongly support the model.

6 Conclusions Bankruptcy risk is of great concern to companies and businesses operating in all sectors of ﬁnancial markets globally. most of which rely on historical data. We also test the model on ﬁrms impacted by the subprime mortgage crisis and the results are striking. However. Furthermore. The average default probability for the global ﬁnancial ﬁrms universe increases steadily since January 2007. The empirical results presented strongly support the model and demonstrate that it is able to distinguish healthy ﬁrms from distressed ﬁrms. and empirically test the model for ﬁrms that have ﬁled for Chapter 11 and global banks that have been impacted by the subprime mortgage crisis. including bankruptcy liquidation and reorganization. Various tools and techniques have been used to assess bankruptcy risk. Brown. This paper presents a forward looking measure that uses stock and option prices to obtain an implied probability of bankruptcy. Furthermore. It is interesting to note that foreign center banks default probabilities increase simultaneously with the US center banks.important contributions to the literature and can be applied in a number of crucial areas of corporate ﬁnance. For example. there is an observed delay for the foreign regional banks and US 28 . Bartram. the model has potential applications in other vital areas of ﬁnance including capital structure. we ﬁnd that the increases in the bankruptcy probability can lead debt ratings changes by a period of up to six months in selected analysis. Our bankruptcy probability estimates are generally consistent with other measures of ﬁrm risk including z-scores. We derive option pricing equations that are similar to Merton’s ruin model. and ﬁnancial markets. which illustrates the ”common shock” eﬀect of global ﬁnancial integration. executive compensation. senior long-term debt ratings. and common stock ratings. and Hund (2005) obtain implied bankruptcy probabilities using our model to study the event of a systemic failure of the global banking system. The biggest increase is observed for the credit services ﬁrms and investment brokerage houses.

regional investment brokerage ﬁrms. which illustrates the ”spillover” eﬀect of the crisis. This evidence suggests that the world ﬁnancial markets are highly integrated and information disseminates very fast across the globe. 29 .

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0 $2.3 13. Chapter 11 filing date is the day that the firm filed for bankruptcy protection.0 22.5 21.047.164.6 10.2 21.3 $442.0 28.2 24. Company Chapter 11 Filing Date 6/28/2001 5/10/2005 7/18/2005 3/27/2002 6/25/2002 5/14/2003 5/16/2002 12/6/2001 12/6/2000 1/30/2004 10/5/1998 9/2/1999 11/15/2001 4/4/2000 12/20/2005 5/17/2005 7/16/2001 12/18/2002 8/15/2001 4/1/2002 3/3/2006 10/8/2005 9/14/2005 11/19/2002 12/3/2001 9/26/2001 10/1/2001 3/7/2001 4/12/2002 4/1/2003 3/2/2004 7/19/1998 4/19/2001 12/29/1999 11/7/2005 6/22/2000 11/27/2002 1/28/2002 11/14/2001 6/7/1999 6/16/2000 6/16/2000 11/14/2000 2/2/2000 δ (%) Last Date Estimated 2/26/2001 3/4/2005 7/21/2005 7/18/2001 4/11/2002 1/28/2002 10/25/2001 11/9/2000 10/9/2000 11/15/2002 4/30/1998 5/28/1999 3/2/2000 6/4/1999 9/19/2005 2/7/2005 4/2/2001 5/28/2002 12/14/2000 12/19/2001 2/23/2006 9/2/2005 7/21/2005 8/4/2000 11/19/2001 6/1/2001 6/11/2001 11/15/2000 8/6/2001 3/6/2003 12/26/2003 5/18/1998 3/13/2001 11/17/1999 2/23/2005 11/29/1999 7/25/2001 7/23/2001 1/18/2001 5/28/1999 5/4/2000 1/5/2000 9/11/2000 7/21/1999 Days to Ch.0 $2.0 $1185. BBBBBB- Total Assets (Million) $5.5 20.0 $866. and the S&P senior long-term debt rating.6 13.5 14.572 $27.5 $30.0 360Networks (USA) aaiPharma Able Laboratories Adelphia Business Solutions Adelphia Communications Allegiance Telecom APW Ltd Arch Wireless Armstrong World Atlas Air Worldwide Holdings Boston Chicken Breed Technologies Burlington Industries CHS Electronics Calpine Corporation Collins & Aikman Corporation Comdisco Conseco Covad Communications Covanta Energy Corporation Dana Corporation Delphi Corporation Delta Air Lines Encompass Services Corporation Enron Corporation Exodus Communications Federal-Mogul Corporation FINOVA Group Flag Telecom Holdings Fleming Companies Footstar FPA Medical Management Friede Goldman Halter Fruit of the Loom FLYi Genesis Health Ventures Genuity Global Crossing Ltd.11 122 66 -3 249 74 466 201 387 57 435 155 94 613 300 91 100 104 200 241 102 10 36 53 825 14 115 110 112 246 25 66 61 36 42 254 203 482 185 296 9 42 161 63 191 Debt Rating B+ CCC . Total assets are listed for the most recent annual report prior to bankruptcy.289.0 $822.441.2 $3185.0 $1.430.1 $ 3.2 12.5 $2.6 11.456.196. B ABCCC BBB+ BBB+ BBB B BBBB B+ CCC+ CC BB BBBB B+ .0 $1103.216.0 $61.660.4 16.050.2 22.596.8 $ 9.309. The implied probability of bankruptcy δ is estimated using Equations 30 and 31.9 4.185.876.0 21.0 $2.1 $ 104.2 $523.0 22.3 $1889.7 $775.4 $10.300.8 $2.392.0 38. Global TeleSystems Harnischfeger Industries Heilig-Meyers InaCom Corporation ICG Communications Integrated Health Services 12.6 $4.0 19.3 12.0 $2401.1 24.005.6 13.1 36. The mean implied probability of bankruptcy δ is the average value estimated over the last six days for which data was available and for which the optimization procedure converges.1 12.0 $3.0 $ 16.8 45.0 $ 21.0 $2994.0 $3.2 33.654.0 $2.8 10.7 10. the number of days prior to bankruptcy filing that the last bankruptcy probability is estimated.2 14.894.0 $ 339.1 32 .5 12. BBB B .6 30.6 55.1 1.150.0 $1.5 8.3 $831.8 $2.8 5.7 61.5 $21.593.7 $2.084.5 $1.0 $3476.Table 1 Implied Probability of Bankruptcy δ Estimated for Public Companies with Traded Options that Filed for Chapter 11 Bankruptcy during January 1998 through December 2006 This table lists the largest public companies with traded stock options that filed for bankruptcy during January 1998 through December 2006.833.499.7 15.393.4 18. Also provided are the last date for which the bankruptcy probability could be estimated.5 29.801.5 7.0 $14. B+ CCC+ BCC B BBB+ BB+ CCC+ .0 $5.7 $3. BBB.020.0 10.2 9.7 $8754.3 $63.2 14.

0 $1753.5 $2291.683.3 15.738. B B $1.6 $3. BBBCCC+ BD CCC BB .0 34.8 $1.889.3 $2043.0 $3.7 $1521.0 $209.645.7 22.7 10. BBD D .692. .9 $5.7 $3.0 $3.0 $8349.6 53.0 49.672.4 10. N.6 $2307.3 $4. CCC .2 24. Airways Group U.4 27.Interstate Bakeries Corporation Iridium LLC/Capital Corporation JumboSports Kaiser Aluminum Corporation LTV Corporation Laidlaw Leap Wireless International Lodgian Loewen Group International Loral Space & Communications Loews Cineplex Entertainment Mariner Post-Acute McLeodUSA Metals USA Metricom Mirant Corporation Motient Corporation National Steel Northwest Airlines Northwestern Corporation OCA Owens Corning Pacific Gas & Electric Paging Network Paragon Trade Brands Peregrine Systems Petroleum Geo-Services ASA Pillowtex Corporation Pinnacle Holdings Polaroid Corporation PSINet Refco Reliance Acceptance Corp.0 46.2 $553.0 54.7 43.5 10.5 4.5 27.2 29.000. U.2 $2137.3 40.3 $33.5 18.197.302.4 $1209.6 36.8 22.0 37.0 $336.1 9/20/2004 7/29/1999 11/5/1997 8/28/2000 7/21/2000 11/30/1999 5/2/2002 7/28/2000 1/12/1999 1/28/2002 4/6/2000 2/23/1999 12/27/2000 1/25/2000 4/16/2001 7/11/2003 3/19/2001 5/22/2000 9/2/2005 4/8/2003 5/2/2005 9/21/2000 4/6/2001 3/2/2000 12/16/1997 6/5/2002 7/30/2002 8/28/2000 8/9/2001 6/15/2001 10/23/2000 10/13/2005 10/3/1997 4/3/2000 9/29/2000 9/22/2000 1/4/2000 4/30/1999 10/9/2003 1/14/2002 10/30/2001 1/14/1999 8/25/2000 1/14/2000 10/4/2000 7/26/2002 11/5/2004 6/28/2000 11/25/2002 2/11/2005 6/4/2001 7/22/2004 2/4/2000 10/15/1999 1/12/2001 2/15/2001 9/18/2000 7/17/2001 11/28/2001 2 14 412 524 158 568 341 502 139 527 309 325 393 649 76 3 291 644 12 156 312 14 0 142 20 107 359 76 282 117 218 4 126 429 302 177 155 132 68 301 497 270 161 137 227 323 447 192 14 -30 539 50 391 -32 110 116 295 674 144 CCC+ .3 29.367.0 $3132. Reliance Group Holdings Rhythm NetConnections RSL Communications Safety-Kleen Singer Company Solutia SpectraSite Holdings Spiegel Sun Healthcare Group Sunbeam Corporation Sunterra Corporation Teligent Communications Touch America Holdings Tower Automotive Trans World Airlines UAL Corporation Ultimate Electronics United Pan-Europe Comm.0 $2.6 24.4 4.9 34.9 66.042.6 $2.7 43.1 36.6 $14.9 $3.0 $4.6 53.0 $1745.0 33 .7 $1164.9 $1253.0 $4.1 14.3 48. B+ CCC+ B .8 $4. BBBCCC BCCC+ BB . B+ BB .598.3 14. Office Products Company Vencor Viatel Warnaco Group Webvan Group Westpoint Stevens Williams Communications Group 9/22/2004 8/13/1999 12/27/1998 2/12/2002 12/29/2000 6/28/2001 4/13/2003 12/20/2001 6/1/1999 7/15/2003 2/15/2001 1/18/2000 1/30/2002 11/14/2001 7/2/2001 7/14/2003 1/10/2002 3/6/2002 9/14/2005 9/14/2003 3/14/2006 10/5/2000 4/6/2001 7/24/2000 1/6/1998 9/22/2002 7/29/2003 11/14/2000 5/21/2002 10/12/2001 5/31/2001 10/17/2005 2/9/1998 6/12/2001 8/1/2001 3/19/2001 6/9/2000 9/12/1999 12/17/2003 11/15/2002 3/17/2003 10/14/1999 2/6/2001 5/31/2000 5/21/2001 6/19/2003 2/2/2006 1/10/2001 12/9/2002 1/11/2005 12/3/2002 9/12/2004 3/5/2001 9/13/1999 5/2/2001 6/11/2001 7/13/2001 6/1/2003 4/22/2002 23.8 15.2 1.8 16.1 23.6 $19.0 $2578.7 33.5 4. B+ CCC CCC .364.3 $6920.333.5 20. B CCC+ BBB.9 15.1 $689.0 $2.5 $1.8 $1677.4 $2372. BBB .0 23.0 $12.101.9 18.S.3 $6.9 $660.755.0 $2.1 $1056.718.059.770.7 8.1 22.368.6 $373.492.163.0 $4.0 $1034.3 $1803.6 40. BBBBB BB+ BB B BBB+ B+ BBCCC CCC+ .0 $467.7 $1.3 10.6 4.415.738.1 67.0 18.2 $25.7 4.9 16.8 12.0 $29.2 $4931.342.3 $1058.992.3 69.468.S.2 52.V.7 10.0 $1422.8 67.0 $2003.0 $2155.037.3 26.2 61.5 $3.5 $1.

5 6.618.9 14.7 24.8 $103. Grace & Company XO Communications Mean 2/21/2005 4/18/2001 4/24/2001 7/21/2002 4/2/2001 6/17/2002 10.4 $1629.R.9 $4.4 34 .1 $7.5 2/9/2005 3/14/2001 1/30/2001 4/18/2002 1/5/2001 10/18/2001 12 34 84 93 87 239 203 BB B BBB+ BB+ BB $2.0 $2509.975.8 14.5 $6876.2 15.Winn-Dixie Stores Winstar Communications World Access WorldCom W.7 12.900.930.

Communications.9 26.8 32.3 31.5 0.3 23.1 8 7. Gas.4 23. Camps and Other Personal and Business Services Motion Pictures Health Services Engineering.9 17.5 24.5 21 19.8 6.6 4.7 23.0 - 1 - 1 1 1 - 1 - 1 - 1 - 4 3 3.1 17. Accounting. Analyzing/Control Inst. Apparel and Other Paper.5 0.9 4.3 26.9 6. SIC Industry Group Mining and Construction Manufacturing Food and Kindred Products Textile Mill Products. Transportation. Printing.6 4.2 2 1 1 1 - 1 1 2 1 1 - 1 1 1 4 1 3 - 1 1 2 6 1 4 1 - 1 2 2 2 - 1 1 - 1 - 2 1 1 1 1 1 - 4 9 8 17 2 7 1 6 1 3.2 5 4.8 23.5 35 .2 20.3 7.4 23. Rooming Houses. & Related Services Total Firms (N) Percentage of Total Firms Implied Probability of Bankruptcy δ . Insurance. Misc.7 2. Metal Prod. Mach & Comp Eq.7 4 3.5 40004999 41004199 45004599 48004899 49004999 50005199 52005999 60006999 70008999 70007099 72007399 78007899 80008099 87008799 - 1 3 12 13 5 1 4 - 39 35.0 32. Other Transportation Equipment Measuring.7 8.7 11 10.4 11 10.4 4.2 109 100 24.4 14.6 4.6 23.3 15.8 25.8 27.6 1.4 0. Primary Metal Ind.8 - 1 - 2 1 1 1 9 1 2 11 - 3 2 1 - 3 1 - 1 7 26 5 0.6 21.9 25.1 23.6 14 12.9 25. and Real Estate Services Hotels. and Sanitary Service Local and Suburban Transit and Related Transportation by Air Communications Electric.7 22.6 15.9 6.5 3 2. Ind.6 Mean δ 27.7 22.3 22.Table 2 Mean Implied Probability of Bankruptcy δ by Industry and Year This table shows the implied probability of bankruptcy δ by industry and year for the sample of distressed firms. Gas and Sanitary Services Wholesale Trade Retail Trade Finance.9 32 29. Manuf.8 20.9 5. The “% of Firms” column total may not sum exactly to 100% because of rounding. etc Products.4 20. Clay. % SIC Code 10001999 20003999 20002099 22002399 26002899 32003399 34003699 37003799 38003999 1998 1 1 1999 3 1 1 2000 4 1 2 2001 10 3 1 1 3 2002 1 2 2 2003 1 3 1 1 2004 2 1 1 2005 2 1 1 2006 2 1 N 2 30 1 7 5 5 5 % Firms 1. & Comm.8 24.5 40.8 30.1 21.8 32. Chemicals & Allied Stone. Electric. Fab.

64 % 20. quartiles.48 % 1.51 % 33.71 % 362 Panel B: Tests of Differences in Probability of Bankruptcy δ This panel presents univariate tests of differences in mean and median values between distressed firms and S&P 500 firms for the probability of bankruptcy δ.49 % 16. maximum.Table 3 Estimated Probability of Bankruptcy Panel A: Descriptive Statistics for Implied Probability of Bankruptcy δ This panel contains the minimum. The Wilcoxon sign-rank Z-statistic provides a test of the null hypothesis that the median values do not differ.65 % 2. Significance levels are indicated as follows: ***1%.09 % 7.51] S&P 500 Firms Mean [Median] 1.67 % 69. Distressed Firms Minimum Quartile 1 Median Quartile 3 Maximum Mean Standard deviation Range N 1.92 [1.46 % 24. respectively.45 % 8. and ranges for the implied probability of bankruptcy δ for sample firms. *10%.65] 14.0001) t-statistic (p-value) Wilcoxon Sign rank Z-statistic (p-value) 15.97 % 109 S&P 500 Firms 0.49 [20. The t-statistic provides a test of the null hypothesis that the mean values of the probability of bankruptcy do not differ between the two groups. Distressed Firms Mean [Median] 24.38 % 67. **5%. means.47 *** (<0.20 % 1.19 % 1.0001) 36 .92 % 1. standard deviations.37 *** (<0. The implied probability of bankruptcy δ is estimated over the period 1998 to 2006 for distressed firms and June through July 2006 for S&P 500 firms.49 % 12.

12=BBB-.06 % 22. April 2005.6 19.83 % b -- Source: S&P Quarterly Default Update & Rating Transitions. The historical S&P global average one-year default rate is also listed for comparison purposes.5 17. Panel B: Comparison of Implied Probability of Bankruptcy δ with Other Risk Measures for Distressed Firms This panel lists mean values for the implied probability of bankruptcy δ and other measures of firm risk for the sample of distressed firms. Firms are grouped into four quartiles based on the implied probability of bankruptcy δ. Average default rate is for the period 1981 to 2004. 7=A+.86 % 2. 13=BB+.54 % -1 5 12 35 16 5 109 N S&P 500 Firms Mean δ 1. Mean δ Quartile 1 Quartile 2 Quartile 3 Quartile 4 N a 8.15 % --N 25 124 132 33 7 --362 S&P Global Average OneYear Default Rate a 0.51 % 16.04 % 0.1 89 z-score 0. 14=BB.58 % 1.07 % 25. The δ for S&P 500 firms is estimated over the period June through July 2006. 10=BBB+. 18=B-. 17=B.(Lower). b Value includes firms rated CCC and lower. 21=C (Lowest). 17=B (Below Average).304 39 S&P Senior LT Debt Rating a 16. 15=BB-.29 % 1. 19=CCC.04 % 27. b The S&P equity rating obtained from Compustat follows a similar numerical scale.2 18.20 % 5.051 -0. 21=C.8 72 S&P Equity Rating b 18. 6=AA.6 12. 7=A+ (Highest). 9=A-.36 % 18.6 4230. as follows: 2=AAA. S&P Long-Term Senior Debt Rating (or Moodys Equivalent) AAA to AA A BBB BB B CCC Below CCC N a Distressed Firms Mean δ -4.71 % 89 Total Assets ($ Millions) 6236. 22=D.634. 18=B. 16=B+ (Average0. 8=A. 16=B+. Z-scores are included if available within one year of the bankruptcy filing date.7 17.84 % 3.Table 4 Comparison of Implied Probability of Bankruptcy δ with Other Measures of Firm Risk Panel A: Comparison of Implied Probability of Bankruptcy δ with Debt Ratings This panel compares the mean implied probability of bankruptcy (δ) for sample firms versus S&P 500 firms sorted according to the senior long-term debt credit rating.5 7526.6 46 The S&P senior long-term debt rating has been converted to the numerical code that Compustat uses.3 19. 4=AA+.28 % 48. Only firms in which the δ is estimated within one year of Chapter 11 filing are included. 20=CC.79 % 30.01 % 0.402 0. 5=AA.71 % 28.181 -0. For example.60 % 1.2 17. 11=BBB. 37 . The δ for distressed firms is measured over the period described in Table 1.90 % 25.

17 % 31. and days to Chapter 11 is measured over the period described in Table 1.8 17.9 Period δ Precedes Debt Rating Change Two to six months One to three months Less than one month Up to six months Firms with credit rating BB or higher Firms with credit rating B or CCC Firms with credit rating CC or lower All above firms 8 36 3 47 31.12 % 42.9 24.04 % 38 .3 17.7 214.2 Mean Days to Ch. Distressed Firms N Mean δ Mean Debt Rating 12.5 214.5 149.11 223. Sample firms are selected whose credit rating was available through Bloomberg. mean debt rating. The debt ratings are converted to numerical code as described in Panel B.38 % 32.Panel C: Comparison of Implied Probability of Bankruptcy δ with Debt Ratings Changes This panel reports the period in months (see column on right) that the implied probability of bankruptcy (δ) increase preceded the debt rating change for the sample of distressed firms. The δ.

00% 5.Table 5 Implied Probability of Bankruptcy (δ) for Firms Impacted by the Subprime Mortgage Crisis This table presents analysis on 9 construction and business services firms impacted by the subprime mortgage crisis. cut 35% of work force. 2007) Expects a $300-$300 million loss related to its planned exit from the subprime market. (Aug. 19. blames a weaker housing market than most predicted. (Oct.17% 24. 26. blaming housing slump and subprimemortgage crisis for slowing auto sales.61% (3/24/08) Year-over-year revenue dropped 32%.00% 2." (Sept. Company (Industry) CarMax (Retailer) Centex (Building Construction) FedEx (Transportation) δ on Jan. 3. 12.67% (3/19/08) 22.05 a share. a subprime credit situation that was deeper than most realized.2% 28. 2007) Representative Barney Frank announces plans to hold hearings in the House Financial Services Committee investigating credit rating agencies role in the subprime mortgage crisis. (Sept. (Oct.44% (4/14/08) KB Home (Building Construction) Lennar (Building Construction) Lowe's (Retail Trade) McGraw Hill (Publishing. 2007) 39 . 27. 20.95% (2/8/08) 9. 6. 19. 2007) 2. Business Services for S&P Subsidiary) PMI Group (Mortgage Insurer) Average 7. (Sept.66% 0. 18.74% 53. especially the housing market. (Sept.58% General Electric (Conglomerate) 0. 2007) Firm will cut earnings estimate.27% 1. (Aug. 2007) 3.50% 22.43% (4/2/08) 8.30% Expects to report a third-quarter loss of about $1.03% (3/31/08) Swung to loss. and deflation in lumber and plywood. 15.31% (4/16/08) Wall Street Journal News (Date) Cut its earnings estimate for fiscal 2008. 2007) Expects EPS at low end of an earlier forecast. 2007) 2. 2007 7. says "freight business has been impacted by the slowing economy. blaming slowing economy. third time in as many quarters that GE's results will be affected by subprime woes. Oversupply of unsold new and resale homes and downward pressure on new home values has worsened in many of our markets as tighter lending standards and related factors suppress demand. 2007) The company took $1 billion in third-quarter charges from significant effects of the mortgage-market disruptions. Analysis is conducted over January 2007 through May 2008.66% (11/14/07) 0. (Sept.31% Maximum δ and Date 17.63% (1/3/08) 30.

33% 6. median.77% 15.23% 5.65% 1.25% 0.97% 2.74% 5.Table 6 Implied Probability of Bankruptcy (δ) for All Financial Firms with Traded Stock Options This table presents the average.Mid-Atlantic Banks Regional .Northeast Banks Regional .93% 32.Southeast Banks Regional .54% 18. and maximum implied probability of bankruptcy δ for all financial firm groups over the period January 2007 through May 2008.81% 11.Pacific Banks Foreign Money Center Banks Foreign Regional Banks Savings & Loans Investment Brokerage .87% Financial Universe Money Center Banks Regional .83% 1.30% 1.95% 2.92% 2. Average (δ) 3.37% 5.23% 10.71% 2.40% 2.55% 5.13% 1.18% 1.34% 3.69% 13.12% 1.18% 16.72% 1.12% 0.92% Max (δ) 9.National Investment Brokerage .Regional Credit Services 40 .25% 10.56% 4.83% 4.95% 5.Midwest Banks Regional .00% 7.31% 1.27% 15.60% 10.Southwest Banks Regional .79% 1.80% 1.60% Median (δ) 3.49% 5.87% 9.

79% 0.84% 2.00% Max (δ) 10.90% 2.Table 7 Implied Probability of Bankruptcy (δ) for All Money Center Banks This table presents the average.01% 0.94% 3.20% 2.94% 0.00% 0.04% 20.54% 1.50% 0.34% Max (δ) 12.20% 1.94% 1.22% 2.00% 14.00% 17.17% 12.38% Date Max δ obtained 3/26/2008 1/8/2008 4/2/2008 11/23/2007 3/20/2008 11/13/2007 2/21/2008 3/20/2008 41 . median.53% 8.02% 2.31% 2.04% 4.14% 11.99% Median (δ) 0.00% 0.50% 0.00% 1.83% 1.00% 0.52% 2.32% 6.98% 2.51% 2.70% 35.92% 9.76% 22.57% 7.68% 13. maximum and date of the maximum implied probability of bankruptcy δ for all money center banks over the period January 2007 through May 2008.37% 1.60% 100.06% 0. Pane A: Money Center Banks Ticker BAC BK C FDC JPM KEY MEL OFG PNC RY STI TCB TD WB WFC Company Name BANKAMERICA CORP BANK OF NEW YORK MELLON CORP CITIGROUP INC FIRST DATA CORP J P MORGAN CHASE & CO KEYCORP NEW MELLON BANK CORP ORIENTAL FINANCIAL GROUP PNC BANK CORP ROYAL BK CDA MONTREAL QUE SUNTRUST BKS INC TCF FINL CORP TORONTO DOMINION BK ONT WACHOVIA CORP NEW WELLS FARGO & CO Average (δ) 1.97% 8.29% 0.82% Median (δ) 0.91% 1.00% 0.00% 0.97% 2.00% 1.33% Date Max δ obtained 3/17/2008 11/16/2007 3/20/2008 8/16/2007 3/17/2008 3/18/2008 6/22/2007 10/15/2007 2/5/2008 3/6/2008 3/20/2008 2/1/2007 1/14/2008 9/25/2007 3/20/2008 Panel B: Foreign Money Center Banks Ticker ABN CS DB IBN ITU MTU UBB UBS Company Name ABN AMRO HLDG NV CREDIT SUISSE GROUP DEUTSCHE BANK AG ICICI BK LTD BANCO ITAU HLDG FINANCIERA S MITSUBISHI UFJ FINL GROUP IN UNIBANCO-UNIAO DE BANCOS BRA UBS AG Country Netherlands Switzerland Germany India Brazil Japan Brazil Switzerland Average (δ) 1.10% 0.42% 3.01% 11.20% 11.45% 100.00% 0.73% 28.35% 1.74% 11.00% 0.00% 0.40% 74.41% 0.32% 2.16% 0.70% 8.76% 0.

63% 1. Ticker BBD BBV BPOP CIB FBP HDB KB RGF Company Name BANCO BRADESCO BANCO BILBAO VIZCAYA ARGENTA Banco Popular BANCOLOMBIA FIRST BANCORP HDFC BANK LTD KOOKMIN BK R & G FINANCIAL CORP Country Brazil Spain Puerto Rico Colombia Puerto Rico India South Korea Puerto Rico Average (δ) 6. median.00% 0.33% 0.00% 1.82% 13.60% 1.61% 15.Table 8 Implied Probability of Bankruptcy (δ) for All Foreign Regional Banks This table presents the average.00% 3.85% 11.89% Max (δ) 52.99% 1.38% 2.24% 16.07% 9.02% 11.71% 9.09% 2. maximum and date of the maximum implied probability of bankruptcy δ for all foreign regional banks over the period January 2007 through May 2008.82% 17.26% Median (δ) 0.29% 0.96% Date Max δ obtained 5/27/2008 1/19/2007 3/31/2008 1/18/2007 3/15/2007 1/16/2008 9/17/2007 2/16/2007 42 .17% 0.46% 9.89% 4.

00% 18.69% 3.Table 9 Implied Probability of Bankruptcy (δ) for Brokerage Firms This table presents the average.92% 3.00% Max (δ) 4.14% 11.82% 1.08% 44.29% 7.18% 2.71% 100.59% 15.19% 6.88% 34.64% 100.66% 13.22% 12.00% 0.61% 12.04% 2.43% 6.60% 24.23% 35.19% 8.43% 4.27% 25.68% 17.70% 4.86% Median (δ) 4.58% 30.37% 1.67% 13.43% Max (δ) 53.86% 1.09% 2.00% 16.00% 23.74% 0.85% 0.61% 0.90% 17.38% 2.73% 0.83% 4.00% 18.27% 3.22% 30.58% 9. Panel A: National Brokerage Firms Ticker AMTD BSC COWN ETFC GS IBKR LEH MER MS NMR OXPS SCHW SEIC TRAD Company Name TD AMERITRADE HLDG CORP BEAR STEARNS COS INC COWEN GROUP INC E TRADE FINANCIAL CORP GOLDMAN SACHS GROUP INC INTERACTIVE BROKERS GROUP IN LEHMAN BROS HLDGS INC MERRILL LYNCH & CO INC MORGAN STANLEY NOMURA HLDGS INC OPTIONSXPRESS HLDGS INC SCHWAB CHARLES CORP NEW SEI CORP TRADESTATION GROUP INC Average (δ) 8.65% 3.35% 1.00% 5.25% 0.78% 1.90% 2.30% 2.59% 100. median.70% 3.82% 3.87% 4.48% 3. maximum and date of the maximum implied probability of bankruptcy δ for all brokerage firms examined over the period January 2007 through May 2008.96% 4.57% 15.78% 6.38% 5.79% 2.55% 5.00% 25.51% 1.33% 6.65% 26.86% Median (δ) 1.85% 100.12% Date Max δ obtained 8/16/2007 3/12/2008 3/7/2008 3/20/2008 3/17/2008 5/1/2008 3/27/2008 3/19/2008 10/10/2007 12/5/2007 3/17/2008 3/18/2008 3/18/2008 2/29/2008 Panel B: Regional Brokerage Firms Ticker AGE BLK FBR GFIG ITG JEF LAB LM NITE RJF SF SWS USO WDR Company Name EDWARDS AG INC BLACKROCK INC FRIEDMN BILLINGS RMSY GFI GROUP INC INVESTMENT TECHNOLOGY GP INC JEFFERIES GROUP INC LABRANCHE & CO INC LEGG MASON INC KNIGHT CAPITAL GROUP INC RAYMOND JAMES FINANCIAL INC STIFEL FINL CORP SOUTHWEST SECURITIES GROUP UNITED STATES OIL FUND LP WADDELL & REED FINL INC Average (δ) 1.50% 2.33% 0.13% 6.03% 0.88% 5.01% 3.00% 39.02% Date Max δ obtained 9/28/2007 4/14/2008 5/27/2008 3/18/2008 3/17/2008 4/7/2008 10/23/2007 5/22/2008 3/20/2008 11/12/2007 7/16/2007 5/12/2008 10/11/2007 8/13/2007 43 .18% 5.93% 35.65% 4.25% 100.

90% 28.Table 10 Implied Probability of Bankruptcy (δ) for All Credit Services Firms This table presents the average.00% 52.90% 18.21% Median (δ) 5.01% 1.01% 12.00% 6.41% 100.75% 8.52% 7.54% 7.43% 0.36% 5.42% 0.00% 7.71% 19.85% 37.57% 7.64% 32.85% Max (δ) 38.05% 9.41% 4.04% 8.91% 7.00% 2.62% 18.54% 1.77% 66.65% 3. Ticker AACC ACF ADS ADVNB AEA AXP CCRT CIT COF CSE CSH EFX EZPW FCFS FMD FNM MCO NNI PHH SFI SLM TAXI WRLD Company Name ASSET ACCEP CAP CORP AMERICREDIT CORP ALLIANCE DATA SYSTEMS CORP ADVANTA CORP ADVANCE AMER CASH ADVANCE CT AMERICAN EXPRESS CO COMPUCREDIT CORP CIT GROUP INC CAPITAL ONE FINL CORP CAPITALSOURCE INC CASH AMER INTL INC EQUIFAX INC EZCORP INC FIRST CASH FINL SVCS INC FIRST MARBLEHEAD CORP FEDERAL NATL MTG ASSN MOODYS CORP NELNET INC PHH CORP STARWOOD FINANCIAL INC SLM CORP MEDALLION FINL CORP WORLD ACCEP CORP DEL Average (δ) 7.77% 45.64% 6.57% 3.39% 31.68% 1.68% 28.82% 5.41% 23.34% Date Max δ obtained 7/17/2007 1/29/2008 1/24/2008 5/2/2008 4/15/2008 10/12/2007 1/16/2008 4/16/2008 3/17/2008 4/9/2008 5/30/2008 1/8/2008 2/20/2008 3/18/2008 3/3/2008 3/18/2008 5/19/2008 5/2/2008 2/6/2008 4/10/2008 3/24/2008 5/23/2008 4/17/2008 44 .00% 0.59% 21.29% 11.12% 7.41% 22.40% 2.70% 4.51% 11.00% 5.47% 67.85% 0.22% 22.44% 2.95% 1.12% 3.56% 21.57% 4.98% 3.72% 0.69% 5.67% 1. median.72% 0.53% 0. maximum and date of the maximum implied probability of bankruptcy δ for all credit services firms examined over the period January 2007 through May 2008.53% 33.54% 3.62% 0.59% 11.48% 9.14% 7.67% 27.50% 1.

Probability of Bankruptcy (Delta) 10% 15% 20% 25% 30% 35% 0% 1/3/2005 1/17/2005 1/31/2005 2/14/2005 2/28/2005 3/14/2005 3/28/2005 4/11/2005 4/25/2005 5/9/2005 5/23/2005 6/6/2005 6/20/2005 7/4/2005 5% Figure 1 Implied Probability of Bankruptcy for Dana Corporation (Chapter 11 Bankruptcy filed 3/3/06) 45 7/18/2005 Date 8/1/2005 8/15/2005 8/29/2005 9/12/2005 9/26/2005 10/10/2005 10/24/2005 11/7/2005 11/21/2005 12/5/2005 12/19/2005 1/2/2006 1/16/2006 1/30/2006 2/13/2006 .

also restated 1999 and 2000 net income retroactiverly.2% on October 15.2 billion equity reduction.0% 25. 2001. 2001. 40.0% November 19.Figure 2 Implied Probability of Bankruptcy for Enron (Note: Enron filed Chapter 11 on December 2. 20.0% Probability of Bankruptcy (Delta) 30.0% 35.0% 10. 2001) 45. the day before Enron announces $544 Million after tax charge and $1.0% 1/7/1999 2/7/1999 3/7/1999 4/7/1999 5/7/1999 6/7/1999 7/7/1999 8/7/1999 9/7/1999 1/7/2000 2/7/2000 3/7/2000 4/7/2000 5/7/2000 6/7/2000 7/7/2000 8/7/2000 9/7/2000 1/7/2001 2/7/2001 3/7/2001 4/7/2001 5/7/2001 6/7/2001 7/7/2001 8/7/2001 10/7/1999 11/7/1999 12/7/1999 10/7/2000 11/7/2000 12/7/2000 9/7/2001 10/7/2001 11/7/2001 Date 46 .0% 5. Enron files its quarterly 10Q.0% Implied Bankruptcy probability of 14. SEC requested information on LJM2.0% 15.0% 0.

00% 0.00% 16.10.00% 6.00% Figure 3 Average Implied Probability of Bankruptcy for Building Construction Firms 47 9/30/2007 10/30/2007 11/29/2007 12/29/2007 1/28/2008 2/27/2008 3/28/2008 4/27/2008 5/27/2008 .00% 8.00% 12.00% 1/3/2007 2/2/2007 3/4/2007 4/3/2007 5/3/2007 6/2/2007 7/2/2007 8/1/2007 8/31/2007 2.00% 14.00% 4.

00% 0.00% 4.00% 6.00% 10.00% 1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008 48 .00% 8.00% 2.Figure 4 Average Implied Probability of Bankruptcy for Global Financial Firms with Traded Stock Options 12.

Figure 5 Average Implied Probability of Bankruptcy for Global Money Center Banks 14.00% 2.00% Money Center Banks Foreign Money Center Banks 49 .00% 12.00% 4.00% 10.00% 8.00% 6.00% 0.00% 1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008 -2.

00% 25.Mid-Atlantic Banks Regional .00% 30.Pacific Banks 50 .00% 10.00% 0.00% 20.00% Regional .Southeast Banks Regional .00% 1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008 -5.Southwest Banks Regional .Figure 6 Average Implied Probability of Bankruptcy for All US Regional Banks 35.Northeast Banks Regional .00% 5.00% 15.Midwest Banks Regional .

00% 6.00% 1/3/2007 4/13/2007 7/22/2007 Foreign Money Center Banks 10/30/2007 Foreign Regional Banks 2/7/2008 5/17/2008 51 .00% 2.00% 10.00% 8.Figure 7 Average Implied Probability of Bankruptcy for All Foreign Center Banks and Foreign Regional Banks 12.00% 4.00% 0.

00% 8.00% 0.00% 2.00% 10.00% 16.00% 4.00% 6.00% 14.00% 12.National 10/30/2007 2/7/2008 5/17/2008 Investment Brokerage .Figure 8 Average Implied Probability of Bankruptcy for All National and Regional Brokerage Firms 18.Regional 52 .00% 1/3/2007 4/13/2007 7/22/2007 Investment Brokerage .

00% 1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008 53 .00% 6.00% 4.00% 0.00% 12.Figure 9 Average Implied Probability of Bankruptcy for All Credit Services Firms 18.00% 8.00% 16.00% 14.00% 2.00% 10.

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