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A Simple Robust Link Between American Puts and Credit Insurance

by Peter Carr of Bloomberg, L.P. & Courant Institute, and
Liuren Wu of Baruch College

May 7, 2008

Abstract: We develop a simple robust link between equity out-of-the-money American put options and a pure credit insurance contract on the same reference company. Assuming that the stock price stays above a barrier B > 0 before default but drops and remains below a lower barrier A < B after default, we show that the spread between two co-terminal American put options struck within the default corridor [A, B] scaled by their strike difference replicates a standardized credit insurance contract that pays one dollar at default whenever the company defaults prior to the option expiry and zero otherwise. Given the presence of the default corridor, this simple replicating strategy is robust to the details of pre- and post-default stock price dynamics, interest rate movements, and default risk fluctuations. We use quotes on American puts to infer the value of the credit insurance contract and compare it to that estimated from the credit default swap spreads. Collecting data on several companies, we identify strong co-movements between the credit insurance values inferred from the two markets. We also find that deviations between the two estimates cannot be fully explained by common variables used for explaining American put values, such as the underlying stock price and stock return volatility, but the cross-market deviations can predict future movements in American puts.

JEL Classification: C13, C51, G12, G13.

Keywords: Stock options, American puts, unit recovery claims, credit default swaps, default probabilities.

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