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Abstract:
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We propose a methodology to estimate the risk-neutral distribution of a firm's expected stock returns by blending option prices and CDS spreads, with option data providing information about the center of distribution, and CDS data determining the left tail. Using this approach to extract the risk-neutral distribution improves on the existing methods by filling the gap left by the illiquidity of deep out-of-the-money options on individual stocks. We apply this methodology to several large firm stock returns. We establish that the estimated risk-neutral skewness predicts negative returns over the next quarter for individual stocks. Combining option and CDS data to construct risk neutral distributions is rooted in the strategic default literature, which suggests that bankruptcy happens before market value of a firm drops to zero. Hence, CDS-based risk neutral probability of default is useful in determining the left tail of the risk neutral distribution of returns since default spans a non-trivial set of a firm's equity returns space. We use estimated returns-to-delisting as the threshold below which the risk-neutral return distribution must be consistent with the default probability.
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