European Puts, Credit Protection, and Endogenous Default

35 Pages Posted: 14 Dec 2018 Last revised: 9 Jan 2020

See all articles by Jorge Cruz Lopez

Jorge Cruz Lopez

University of Western Ontario; Financial Network Analytics (FNA)

Alfredo Ibañez

Comillas Pontifical University

Date Written: December 16, 2019

Abstract

In a default corridor [0,B] that the stock price can never enter, a deep out-of-the-money American put replicates a pure credit contract (Carr and Wu, 2011). Assuming discrete (one-period-ahead predictable) cash flows, we show an endogenous credit-risk model generates, along with the default event, a default corridor at the cash-outflow dates, where B>0 is given by these outflows (i.e., debt service and negative earnings minus dividends). In this endogenous setting, however, the credit-contract replicating put is not American, but rather European. Specifically, the crucial assumption that determines an endogenous default corridor at the cash-outflow dates is that equityholders' deep pockets absorb these outflows; that is, no equityholders's fresh money, no endogenous corridor.

Keywords: equity puts, endogenous default, default corridor, credit risk, insurance

JEL Classification: G10, G12, G13

Suggested Citation

Cruz Lopez, Jorge and Ibañez, Alfredo, European Puts, Credit Protection, and Endogenous Default (December 16, 2019). Available at SSRN: https://ssrn.com/abstract=3288428 or http://dx.doi.org/10.2139/ssrn.3288428

Jorge Cruz Lopez

University of Western Ontario ( email )

Social Science Centre, Room 4071
London, Ontario N6A 5C2
Canada
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HOME PAGE: http://economics.uwo.ca/people/faculty/cruzlopez.html

Financial Network Analytics (FNA) ( email )

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London, EC2A 4BT
United Kingdom

HOME PAGE: http://fna.fi/company/jorge-cruz-lopez/

Alfredo Ibañez (Contact Author)

Comillas Pontifical University ( email )

Alberto Aguilera 21
Madrid, Madrid 28015
Spain

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