Journal
JOURNAL OF FINANCIAL ECONOMICS
Volume 67, Issue 3, Pages 511-529Publisher
ELSEVIER SCIENCE SA
DOI: 10.1016/S0304-405X(02)00260-X
Keywords
security valuation; barrier option; bankruptcy prediction
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This paper proposes a framework for corporate security valuation based on path-dependent, barrier option models instead of the commonly used path-independent approach. We argue that path dependency is an intrinsic and fundamental characteristic of corporate securities because equity can be knocked out whenever a legally binding barrier is breached. A direct implication of this framework is that equity will be priced as a down-and-out call option. We provide empirical validation of the barrier model by showing that implied barriers are statistically and economically significant for a large cross-section of industrial firms. Additional robustness tests confirm that barriers remain significant over a wide range of input variable estimates. And finally, we apply the barrier option framework to bankruptcy prediction and find that implied failure probabilities dominate Z-scores in most cases. (C) 2002 Elsevier Science B.V. All rights reserved.
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