Equity Misvaluation and Default Options

Abstract

We study whether default options are mispriced in equity values by employing a structural equity valuation model that explicitly takes into account the value of the option to default (or abandon the firm) and uses firm-specific inputs. We implement our model on the entire cross section of stocks and identify both over- and underpriced equities. An investment strategy that buys undervalued stocks and shorts overvalued stocks generates an annual four-factor alpha of about 11% for U.S. stocks. The model's performance is stronger for stocks with a higher value of the default option, such as distressed or highly volatile stocks.