Pricing the Default Risk Factor of Short-Term Debt in the Iranian Capital Market Via Compound Option Approach

Articles in Press

Document Type : Research Paper

Authors

1 Ph.D. Candidate in Finance - Financial Engineering, Faculty of Economics, Management and Administrative Sciences, Semnan University, Semnan, Iran

2 Associate Prof., Department of Business Management, Faculty of Economics and Management and Administrative Sciences, Semnan University, Semnan, Iran.

3 Associate Prof., Department of Business Management , Faculty of Economics, Management and Administrative Sciences, Semnan University, Semnan, Iran

Abstract

Purpose: This study introduces short-term debt default risk as a novel factor within asset pricing models and investigates its effect on improving their explanatory power in the Iranian capital market.

Methodology: In this research, the default probabilities of short-term debts for companies listed on the Tehran Stock Exchange (TSE) and Iran Fara Bourse (IFB) between 2004 and 2023 were estimated using Geske's structural model based on compound options, solved through a system of nonlinear equations using numerical algorithms. Subsequently, the short-term debt default risk factor was calculated using these probabilities and integrated into multifactor asset pricing models. To empirically assess the performance of the extended models, time-series regressions were first performed on a set of test assets characterized the presence of short-term debt default probability. To verify the robustness of the findings, similar analyses were also performed on assets lacking this characteristic.

Findings: The results indicate that incorporating the short-term debt default risk factor into multifactor asset pricing models significantly enhances their explanatory power in explaining stock returns. This improvement was observed both in the group of assets with short-term debt default probabilities and in the group without this characteristic.

Research Innovation: For the first time in Iran's capital market, this research estimates the short-term debt default risk factor using Geske's structural model based on compound options and empirically assesses the incremental effect of adding this factor to multifactor asset pricing models in explaining stock returns.

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Main Subjects

Journal of Asset Management and Financing

Articles in Press, Accepted Manuscript
Available Online from 23 August 2025

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