European Puts, Credit Protection, and Endogenous Default

Jorge Cruz López () and Alfredo Ibáñez ()
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Jorge Cruz López: Financial Network Analytics (FNA) and Department of Economics, Faculty of Social Science, University of Western Ontario, 1151 Richmond Street, London ON, Canada N6A 5C2

Quarterly Journal of Finance (QJF), 2021, vol. 11, issue 01, 1-24

Abstract: 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, A Simple Robust Link between American Puts and Credit Protection, Review of Financial Studies 24, 473–505). Assuming discrete (one-period-ahead predictable) cash flows, we show that an endogenous credit-risk model generates, along with the default event, a default corridor at the cash-outflow dates, where B>0 is given by these outflows (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. Specifically, the crucial assumption that determines an endogenous default corridor at the cash-outflow dates is that equityholders’ deep pockets absorb these outflows; that is, no equityholders’ fresh money, no endogenous corridor.

Keywords: Default corridor; endogenous default; equity puts; credit default swaps; tail risk (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1142/S2010139221500014

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