Get access

Options on Troubled Stock

Authors

  • António Câmara,

    1. António Câmara (deceased) was the Watson Family Chair in Commodity and Financial Risk Management and Associate Professor of Finance in the Finance Department, Spears School of Business, Oklahoma State University, Stillwater, Oklahoma
    Search for more papers by this author
  • Ivilina Popova,

    Corresponding author
    1. Ivilina Popova is Associate Professor of Finance at the McCoy College of Business Administration, Texas State University – San Marcos, San Marcos, Texas
    • Correspondence author, McCoy College of Business Administration, Texas State University – San Marcos, San Marcos, TX 78666. Tel: 512-245-1733; Fax: 512-245-3089, e-mail: ip12@txstate.edu

      **Correspondence author, Spears School of Business, Oklahoma State University, Stillwater, OK 74078. Tel: 405-744-8625; Fax: 405-744-5180, e-mail: betty.simkins@okstate.edu, Internet: http://spears.okstate.edu/(simkins)

    Search for more papers by this author
  • Betty Simkins

    Corresponding author
    1. Betty Simkins is the Williams Companies Professor of Business and Professor of Finance in the Finance Department, Spears School of Business, Oklahoma State University, Stillwater, Oklahoma
    • Correspondence author, McCoy College of Business Administration, Texas State University – San Marcos, San Marcos, TX 78666. Tel: 512-245-1733; Fax: 512-245-3089, e-mail: ip12@txstate.edu

      **Correspondence author, Spears School of Business, Oklahoma State University, Stillwater, OK 74078. Tel: 405-744-8625; Fax: 405-744-5180, e-mail: betty.simkins@okstate.edu, Internet: http://spears.okstate.edu/(simkins)

    Search for more papers by this author

  • We wish to thank Bob Webb, the editor, and the referee for their valuable comments. Furthermore, we appreciate the discussant feedback from Craig Lewis, Christophe Villa, and Ahaodong Zhong that they provided at the Financial Management Association (FMA) European Conference, Eastern Finance Association Conference, and FMA Annual Conference, respectively.
  • We dedicate this paper to the memory of Antonio Camara.

Abstract

This study uses equilibrium arguments to derive closed-form solutions for the price of European call and put options written on an individual stock when shareholders might lose all their claims on the firm. The stock price accounts for both a random probability of bankruptcy and a random probability of remaining a going concern. With a random probability of bankruptcy, shareholders lose all their claims in the firm. With a random probability of remaining a going concern, the stock price is lognormal as in the Black–Scholes model. The bankruptcy probability is correlated with aggregated wealth if the bankruptcy risk is systematic. The model is consistent with a bankruptcy probability negatively correlated with the firm's stock price. If the bankruptcy probability of a given firm increases then its stock price decreases which leads to the value of the call options written on that stock to decrease. This result is not obtainable under Merton's (1976) ruin model where the stock price and the bankruptcy probability are independent. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark 34:637–657, 2014

Ancillary