OPTIONS ON LEVERAGED EQUITY - THEORY AND EMPIRICAL TESTS

We develop an option pricing model for calls and puts written on lever aged equity in an economy with corporate taxes and bankruptcy costs. T he model explains implied Black-Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and deb t covenants. We test the model by comparing predicted pricing biases w ith biases observed in a large cross-section of firms with liquid exch ange traded option contracts. Our empirical study detects leverage rel ated pricing biases. The magnitudes of these biases correspond to thos e predicted by our model. We also find significant pricing biases for firms financed primarily by shortterm debt. This supports our model be cause short-term debt introduces net-worth hurdles similar to net-wort h covenants.