Using Equity Puts to Hedge Corporate Credit Losses

Summary

The document considers buying put options on a company’s equity as a hedge against losses on its debt. The proposed intuition is that a default could drive equity toward zero, making puts more valuable and potentially offsetting some loss given default. If the company avoids default, coupon income from the debt may help bear the option cost. The material does not develop a complete hedge construction or quantify its effectiveness.

The responses characterize the idea as an established strategy and identify a practical constraint: listed put markets may not offer enough size to match the notional of typical credit positions. They also discuss bounds on deeply out-of-the-money put values inferred from credit spreads: an upper bound related to an at-the-money put and a lower bound tied to the discounted strike and credit-implied default probability. The notes are pointers rather than a full empirical study; hedge performance, basis risk, option liquidity, and the assumptions linking default to equity value remain unresolved.

Key ideas

• Equity puts may gain value when a firm defaults and its share price falls, partially offsetting credit losses.
• Debt coupon income may help pay for the put premium when default does not occur.
• Put market capacity can be too limited to hedge the notional of a typical credit instrument.
• Credit spreads can be used to derive bounds for deeply out-of-the-money put values.
• The proposed hedge depends on how default, equity value, and option liquidity relate in practice.

Tags

# Hedging credit risk using Put equity options


# Hedging credit risk using Put equity options












I am looking for some paper or similar which deal with this topic: hedging bankruptcy on firm's debt using Put options written on that firm's equity price.

This should be based on the assumption that equity price goes zero if firm defaults, then Put options go ITM and profits (partially) cover LGD; on the other hand, if no default occurs you have regular coupon payments that can make Put cheaper than naked long position.

Any reference?

## Answer by Brian B (score 3, accepted)

https://quant.stackexchange.com/a/7923

This is, of course, a very old play. The main thing that gets in the way of trading it is that puts are rarely available in a quantity that matches typical credit instrument notionals.

Here's a decent paper by Peter Carr on the topic, see equation (4) and surrounding.

## Answer by Vince (score 0)

https://quant.stackexchange.com/a/7928

from my reading of Gatheral's notes on this strategy, the best you can hope for at this point, given that the strategy is indeed old hat as Brian states, are bounds on the price of deeply OTM puts as implied by credit spreads of associated tenor. turns out the upper bound is the value of the associated ATM put option and is independent of the credit spread. As for the lower bound, it is nothing more than the present value of the strike price times the probability of default implied by the credit spread. There is a nice anecdote in Gatheral's book about how hedge funds back in the day took it to market makers who got repeatedly burned in connection with implied vol skew.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.