European puts, credit protection, and endogenous default

Arbeitspapier

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

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: Research Report ; No. 2020-5

Classification and Topics

• Classification: Wirtschaft
• Subject: default corridor ; endogenous default ; equity puts ; credit default swaps ; tail risk

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Cruz López, Jorge ; Ibáñez, Alfredo
• Event: Veröffentlichung
• (who): The University of Western Ontario, Department of Economics
• (where): London (Ontario)
• (when): 2020

Further information

• Handle: http://hdl.handle.net/10419/247637
• Last update: 10.03.2025, 11:43 AM CET