Capital Structure Effects on the Prices of Individual Equity Call Options

The purpose of this paper is to examine whether equity options traded on individual firms are sensitive to the firm’s leverage, and to see if adding leverage to the option model improves its pricing accuracy. In a hitherto unexamined economic approach to option valuation, we use reported leverage from financial statements, and a compound option (CO) model, for valuing stock options on individual firms’ equities. Recall that in the CO model, equity is a call option on the firm with the amount of leverage being the “strike price,” while the call option on equity is the second option in sequence. We demonstrate cross-sectional and timeseries effects of leverage on option values in a manner consistent with the CO model. We compare this model to the seminal Black-Scholes (BS) model which is a special case of the CO model when the firm has no debt. We demonstrate that differences in capital structure have significant statistical and economic cross-sectional and time-series effects on the prices of individual equity call options. When capital structure effects are incorporated into option pricing, the CO model produces values that are closer to market prices and reduces pricing errors of equity call options by 20% on average, relative to the BS model. We also show that these percentage pricing improvements, while small for firms with little leverage, are monotonically increasing to up to 70% with respect to both leverage and time to option expiration. JEL Classification: G12.