Updating the option implied probability of default methodology

Johannes Vilsmeier

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Need to know

Technical updates to the "option iPoD" procedure suggested in Capuano (2008).
New objective function guarantees robust estimation of risk neutral densities.
New algorithm to derive option implied probabilities of default.
Numerical evaluations suggest high accuracy of the framework.

Abstract

ABSTRACT

In this paper, we update the option implied probability of default (iPoD) approach recently suggested in the literature. First, a numerically more stable objective function for the estimation of the risk-neutral density is derived, whose integrals can be solved analytically. Second, it is reasoned that the originally proposed approach for the estimation of the PoD produces arbitrary results; hence, an alternative procedure-based on the Lagrange multipliers - is suggested. Based on numerical evaluations and an illustrative empirical application, we conclude that the framework provides very promising results.

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