A Simple Robust Link between American Puts and Credit Protection

62 Pages Posted: 25 Nov 2008 Last revised: 6 Nov 2010

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: November 24, 2008

Abstract

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

Carr, Peter P. and Wu, Liuren, A Simple Robust Link between American Puts and Credit Protection (November 24, 2008). Bloomberg Portfolio Research Paper No. 2009-07-FRONTIERS. Available at SSRN: https://ssrn.com/abstract=1306474

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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