Option-Implied Debt Stress Index for Emerging Conglomerates: A Market-Calibrated Framework for Default-Risk Decomposition

Abstract

The new Option-Implied Debt Stress Index (DSI) proposed in
this paper will help to measure and decompose the risk of default of
emerging market conglomerates over a market-calibrated framework.
The study integrates option-implied volatility and structural credit risk
modelling to construct a forecaster and includes all current financial
strains. According to the information of the equity of firms and
derivatives, the primary indicators, such as the implied volatility,
distance-to-default, and default probability, are calculated and combined
in the DSI. The empirical findings will indicate that the company will have
a high implied volatility (2.11) compared to the rest (average 0.37), which
will imply much smaller distance-to-default (1.07) and thus increased
probability of default (16.5). Such a classification of DSI points to the fact
that 27 percent and 43 percent of the firms are highly risky and
moderately risky respectively. The time-series analysis indicates that the
mean DSI is greater during crisis periods when it is 0.78 compared to the
period when markets are stable when the mean is 0.34 and such property
is very sensitive to the stress of the market. Further risk decomposition
findings show that, out of the total 100 percent of the overall stress of debt,
idiosyncratic (42) and systemic (35) risk factors and volatility-driven (23)
factors are included. The findings are in line with the practicality of
options-implied options when modeling prospective credit risk. The
proposed framework is a powerful resource, which can be used by
investors and policymakers to monitor financial stability and observe the
initial warning signs in the growing markets.