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European Puts, Credit Protection, and Endogenous Default

Author

Listed:
  • 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)

  • Alfredo Ibáñez

    (Universidad Pontificia Comillas, ICADE, c/ Alberto Aguilera 23, 28015 Madrid, Spain)

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.

Suggested Citation

  • Jorge Cruz López & Alfredo Ibáñez, 2021. "European Puts, Credit Protection, and Endogenous Default," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 11(01), pages 1-24, March.
    • Handle: RePEc:wsi:qjfxxx:v:11:y:2021:i:01:n:s2010139221500014
    DOI: 10.1142/S2010139221500014
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