Prediction of default risk: An options-based approach applied to the Brazilian banking sector

This article proposes a methodological framework to construct an early warning system for the Banking sector. It employs an options-based methodology to estimate default risk for six major Brazilian banks and shows that these measures have informational content. In addition, the options-based indicator is compared with market-based financial fragility indicators. Results show that these indicators are useful for risk managers and regulators, especially during crisis. Furthermore, option-based methods are preferable to classify banks. Finally, there is some evidence of lack of market discipline in the early 1990s. © 2011 Macmillan Publishers Ltd.