Options on Leveraged Equity: Theory and Empirical Tests.

The authors 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. The authors test the model by comparing predicted pricing biases with biases observed in a large cross-section of firms with liquid exchange traded option contracts. Their empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by their model. The authors also find significant pricing biases for firms financed primarily by short-term debt. This supports their model because short-term debt introduces net-worth hurdles similar to net-worth covenants. Copyright 1997 by American Finance Association.