Pricing Credit from Equity Options

Pricing Credit from Equity Options – Market Model We show that the arbitrage relationship between credit and equity derivatives derived in this paper can be enforced via dynamic hedging of credit derivatives with Gamma-flat risk reversals. In the course of implementing trading strategies based on structural models it became apparent that the models are not true no-arbitrage models in the sense that they do not identify riskless arbitrage portfolios which can be traded when market CDS prices deviate from the model predictions. From this perspective, the structural models define some sort of "fair value" in the same way as Capital Asset Pricing Model defines an equilibrium "fair value" for the share returns. The step which we are taking in this paper is a derivation of a no-arbitrage approach to valuation of credit derivatives based on existence of an arbitrage portfolio of stocks and equity options such that trading the portfolio can enforce the no-arbitrage relationship. The reader can look at the suggested here analysis as a generalisation of the standard Black-Scholes analysis to the case of defaultable underlying assets. download paper