Journal of Computational Finance

Risk.net

Updating the option implied probability of default methodology

Johannes Vilsmeier

  • 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

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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