A barrier option framework for corporate security valuation

Abstract This paper proposes a framework for corporate security valuation based on path-dependent, barrier option models instead of the commonly used path-independent approach. We argue that path dependency is an intrinsic and fundamental characteristic of corporate securities because equity can be knocked out whenever a legally binding barrier is breached. A direct implication of this framework is that equity will be priced as a down-and-out call option. We provide empirical validation of the barrier model by showing that implied barriers are statistically and economically significant for a large cross-section of industrial firms. Additional robustness tests confirm that barriers remain significant over a wide range of input variable estimates. And finally, we apply the barrier option framework to bankruptcy prediction and find that implied failure probabilities dominate Z-scores in most cases.