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A Simple Robust Link Between American Puts and Credit Protection

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Author Info

  • Peter Carr
  • Liuren Wu

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. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rfs/hhq129
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Bibliographic Info

Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 24 (2011)
Issue (Month): 2 ()
Pages: 473-505

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Handle: RePEc:oup:rfinst:v:24:y:2011:i:2:p:473-505

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Cited by:
  1. Peter Christoffersen & Du Du & Redouane Elkamhi, 2013. "Rare Disasters and Credit Market Puzzles," CREATES Research Papers 2013-45, School of Economics and Management, University of Aarhus.

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