Simple Robust Linkages between CDS and Equity Options

46 Pages Posted: 25 Mar 2008

See all articles by Peter Carr

Peter Carr

New York University Finance and Risk Engineering

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Date Written: March 18, 2008

Abstract

We test a theory that provides a simple and robust linkage between the market prices of credit default swaps (CDS) and far out-of-the-money equity American put options on the same reference company. The linkage is established under a general class of stock price dynamics. We assume that the stock price stays above a barrier B>0 before default but drops below a lower barrier A at default and stays blow A thereafter. We further assume that investors can take a static position in at least two American put options with the same expiry date and struck within this default corridor [A,B]. We show that a vertical spread of such options scaled by the spread between the two strikes replicates a standardized credit insurance contract that pays one dollar at default whenever the company defaults prior to the option expiry and zero otherwise. Given the existence of the 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 the American put spread to infer risk-neutral default probabilities and compare them to those estimated from the CDS spreads. Collecting CDS and American stock options data on several companies, we identify strong co-movements between the risk-neutral default probabilities inferred from the two markets. We also find that deviations between the two estimates predict future movements in both markets. In particular, the cross-market deviations predict future returns on the American put spread that synthesizes the credit insurance contract.

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

JEL Classification: C13, C51, G12, G13

Suggested Citation

Carr, Peter P. and Wu, Liuren, Simple Robust Linkages between CDS and Equity Options (March 18, 2008). Available at SSRN: https://ssrn.com/abstract=1107986 or http://dx.doi.org/10.2139/ssrn.1107986

Peter P. Carr

New York University Finance and Risk Engineering ( email )

6 MetroTech Center
Brooklyn, NY 11201
United States
9176217733 (Phone)

HOME PAGE: http://engineering.nyu.edu/people/peter-paul-carr

Liuren Wu (Contact Author)

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

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