A simple robust link between american puts and credit protection

Peter Carr, Liuren Wu

Research output: Contribution to journalArticle

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.

Original languageEnglish (US)
Pages (from-to)473-505
Number of pages33
JournalReview of Financial Studies
Volume24
Issue number2
DOIs
StatePublished - Feb 1 2011

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ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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