use of call_and_put_options

Jun 28th, 2015
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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. (JEL C13, C51, G12, G13)

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A Simple Robust LinkBetween American Puts and Credit ProtectionPeter CarrCourant Institute, New York UniversityLiuren WuZicklin School of Business, Baruch College, The City University of New YorkAbstractWe develop a simple robust link between deep out-of-the-money American put options on a companys stock and a credit insurance contract on the companys bond. We assume that the stockprice stays above a barrier B before default but drops below a lower barrier A after default, thusgenerating a default corridor [A, B] that the stock price can never enter. Given the presence of thisdefault corridor, a spread between two co-terminal American put options struck within the corridorreplicates a pure credit contract paying off when and only when default occurs prior to the optionexpiry. (JEL C13, C51, G12, G13)We thank Raman Uppal (the editor), an anonymous referee, Yakov Amihud, Arthur Berd, Menachem Brenner, RossGaron, Sanjay Dasgupta, Darrell Duffie, Bruno Dupire, Robert Engle, Stephen Figlewski, Bjorn Flesaker, Eric Ghysels, Kay Giesecke, Haitao Li, Ziqiang Liu, Dilip Madan, Eric Rosenfeld, Ian Schaad, Marti Subrahmanyam, SergeTchikanda, Andrea Vedolin, Arun Verma, Yan Wang, David Weinbaum, Robert Whitelaw, and seminar participantsat the Society for Financial Econometrics 2008 Inaugural Conference, the 2008 Western Finance Association meetings, the 2008 China International Conference in Finance, 2009 ICBI Global Derivatives Conference, Baruch College, Bloombe

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