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Brockman, Paul and Harry J. Turtle, "A Barrier Option Framework for Corporate Security Valuation", Journal of Financial Economics, Vol. 67, No. 3, (March 2003), pp. 511-29.

Abstract: This paper proposes a framework for corporate security valuation based on path-dependent, barrier option models instead of the commonly used path-independent approach. We argue that path dependency is an intrinsic and fundamental characteristic of corporate securities because equity can be knocked out whenever a legally binding barrier is breached. A direct implication of this framework is that equity will be priced as a down-and-out call option. We provide empirical validation of the barrier model by showing that implied barriers are statistically and economically significant for a large cross-section of industrial firms. Additional robustness tests confirm that barriers remain significant over a wide range of input variable estimates. And finally, we apply the barrier option framework to bankruptcy prediction and find that implied failure probabilities dominate Z-scores in most cases.

JEL Classification: G12, G33.

Keywords: Security valuation, Barrier option, Bankruptcy prediction.