European Puts, Credit Protection, and Endogenous Default

Jorge Cruz Lopez and Alfredo Ibanez
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Jorge Cruz Lopez: University of Western Ontario, https://economics.uwo.ca/

No 20205, University of Western Ontario, Departmental Research Report Series from University of Western Ontario, Department of Economics

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). 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. Specifcally, 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's fresh money, no endogenous corridor.

Keywords: default corridor; endogenous default; equity puts; credit default swaps; tail risk (search for similar items in EconPapers)
Date: 2020
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