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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?

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2 Answers 2

up vote 3 down vote accepted

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.

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Am I the only one who gets 404 - PAGE NOT FOUND when trying to open Biran B's link? –  Lisa Ann May 7 '13 at 17:56
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tried a different link –  Brian B May 7 '13 at 18:01

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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