A Simple Robust Link between American Puts and Credit Protection
62 Pages Posted: 25 Nov 2008 Last revised: 6 Nov 2010
Date Written: November 24, 2008
We develop a simple robust link between deep out-of-the-money American put options on a company's stock and a credit insurance contract on the company's bond. We assume that the stock price stays above a barrier B before default but drops below a lower barrier $A$ after default, thus generating a default corridor [A,B] that the stock price can never enter. Given the presence of this default corridor, a spread between two co-terminal American put options struck within the corridor replicates a pure credit contract, paying off when and only when default occurs prior to the option expiry.
Keywords: Stock options, American puts, unit recovery claims, credit default swaps, default probabilities
JEL Classification: C13, C51, G12, G13
Suggested Citation: Suggested Citation