A Simple Robust Link between American Puts and Credit Protection

Abstract:     
We develop a simple robust link between out-of-the-money American-style equity put options and a pure credit insurance contract on the same reference company. We assume that the stock price stays above a barrier B>0 before default but drops and remains below a lower barrier A after default. Under these dynamics, a spread between two co-terminal American put options struck within the default corridor [A,B] and scaled by its strike difference replicates a standardized credit insurance contract paying one dollar at default if and only if default occurs prior to the common option expiry. Given the presence of this default corridor, this simple replicating strategy is robust to the details of pre- and post-default stock price dynamics, interest rate movements, and default risk fluctuations. We use quotes on American puts to infer the value of the credit insurance contract and compare it to that estimated from credit default swap spreads. Collecting data on several companies, we identify strong co-movements between the credit insurance values inferred from the two markets. We also find that deviations between the two estimates cannot be fully explained by common variables used for explaining American put values, such as the underlying stock price and stock return volatility, but the cross-market deviations can predict future movements in American put prices.

Keywords: Stock options, American puts, unit recovery claims, credit default swaps, default probabilities

JEL Classifications: C13, C51, G12, G13

Working Paper Series