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Options on Leveraged Equity: Theory and Empirical Tests

Authors

  • KLAUS BJERRE TOFT,

  • BRIAN PRUCYK

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    • University of Texas at Austin. This article extends an earlier article by Toft entitled “Options on Leveraged Equity with Default Risk.” We thank David Chapman, Richard Hydell, Mark Huson, Jens Carsten Jackwerth, Jason Karceski, William Keirstead, Hayne Leland, Robert Parrino, Ehud Ronn, Mark Rubinstein, Duane Seppi, Laura Starks, Kehong Wen, and two anonymous referees for their valuable comments. Furthermore, the article was improved by incorporating comments from participants at the 1995 Annual Meeting of the Western Finance Association, the 1996 Financial Management Association Meetings, the 1997 Annual Meeting of the American Finance Association, and from seminar participants at the University of Aarhus, University of California, Berkeley, University of Houston, and the University of Texas at Austin. Finally, Toft gratefully acknowledges financial support from the Institute for Quantitative Research in Finance and the Danish Social Science Research Council, Grant No. 14–6076.


ABSTRACT

We develop an option pricing model for calls and puts written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The model explains implied Black-Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and debt covenants. We test the model by comparing predicted pricing biases with biases observed in a large cross-section of firms with liquid exchange traded option contracts. Our empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by our model. We also find significant pricing biases for firms financed primarily by short-term debt. This supports our model because short-term debt introduces net-worth hurdles similar to net-worth covenants.

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