Firm valuation and default probability through exotic (barrier) options
Gaston Milanesi, Gabriela Pesce and Emilio El Alabi
Real option theory allows using financial option models to value investments and firms. Traditional models present a substantial problem to positively correlate underlying asset volatility with firm value. Therefore, an alternative approach is used based on a particular type of exotic option, the barrier one. This dynamic model helps estimating default probability incorporating the negative impact that excessive risk has on firm value. The article presents a hypothetical example illustrating similarities and differences between the proposed model and the traditional version. Finally, this model is applied on two of the leading companies in the Argentinean capital market which are characterized by different levels of leverage demonstrating the robustness of the results. The predicted default probability increases with the rise in assets volatility and the time horizon of debt maturity.