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Synthetizing a debt guarantee: Super-replication versus utility approach

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  • Jacques, Sébastien
  • Lai, Van Son
  • Soumaré, Issouf
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    Abstract

    This paper compares two strategies for replicating a put option used to synthetize a debt guarantee contract. The first strategy, super-replication, while maintaining the portfolio value greater or equal to a target value, minimizes the transaction cost of replicating a debt insurance put option by using dynamic linear programming. The second strategy replicates this put option by maximizing the guarantor's expected utility. A comparative study shows that both strategies give better results than the Leland (1985) method. If we use a risk-adjusted performance metric, the utility-based method performs best when transaction costs are relatively low. When transaction costs are relatively high, the two strategies yield similar results and still outperform Leland's.

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    Bibliographic Info

    Article provided by Elsevier in its journal International Review of Financial Analysis.

    Volume (Year): 20 (2011)
    Issue (Month): 1 (January)
    Pages: 27-40

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    Handle: RePEc:eee:finana:v:20:y:2011:i:1:p:27-40

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    Web page: http://www.elsevier.com/locate/inca/620166

    Related research

    Keywords: Debt guarantee Synthetic put option Hedging Replication Transaction costs;

    References

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