Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/247637 
Year of Publication: 
2020
Series/Report no.: 
Research Report No. 2020-5
Publisher: 
The University of Western Ontario, Department of Economics, London (Ontario)
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 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.
Subjects: 
default corridor
endogenous default
equity puts
credit default swaps
tail risk
Document Type: 
Working Paper

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