Researcher ORCID Identifier

0009-0002-0723-1373

Graduation Year

2026

Date of Submission

12-2025

Document Type

Campus Only Senior Thesis

Degree Name

Bachelor of Arts

Department

Economics

Reader 1

Eric Hughson

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© 2025 Kiefer S Tierling

Abstract

This thesis investigates whether forward-looking volatility information from equity options enhances the predictive accuracy of Merton (1974) distance-to-default (DD) measures. Using a monthly panel of U.S. public firms (2007 – 2022), constructed from Center for Research in Security Prices (CRSP), Compustat, Option Research & Technology Services (ORATS) near end-of-day option quotes, and Lopucki bankruptcy outcomes, I construct three DD measures: a historical-volatility DD, an implied-volatility DD, and a hybrid DD that forms a convex combination of the two. The hybrid weight is re-estimated each year in a two-window rolling design, where the prior year is used to calibrate the weight that maximizes the Receiver Operating Characteristic (ROC) Area Under the Curve (AUC) and the subsequent year is used strictly for out-of-sample evaluation. Across pooled tests and nearly all out-of-sample windows, the hybrid DD achieves the highest AUC, followed by the implied-volatility DD and historical DD. Results are robust across alternative horizons (6-, 12-, and 24-month) and across hybrid constructions (both linear and variance-weighted). DeLong tests and bootstrap resampling confirm that these improvements are statistically significant. Robustness checks, including Kealhofer-Merton-Vasicek (KMV) asset-volatility inversion, industry-level evaluations, and a volatility-risk-premium (VRP) extension, yield consistent results. Overall, forward-looking option-implied volatility materially improves structural default risk measurement.

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