Consistent pricing of equity and credit derivatives

• Main Author: Alessandro, Muci
• Published: Imperial College London 2008
• Subjects: 332
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.486886

The literature on the pricing of equity and credit securities developed more or less independently. Only recently have the two strands merged in the valuation of convertible bonds (corporate bonds with embedded stock options). The subject of our thesis is to describe how both credit and equity securities can be priced in a consistent way so we can enlarge the information set of one market using the information set of the other. Chapter 2 extends the building blocks of Ericsson & Reneby (1998) to the case of exponential barriers and derives a number of simple claims; using these, it is possible to nest five classical structural models and derive an extended version of the Leland & Toft model (1996). The following chapter provides the option pricing extension for the models in Chapter 2 by extending the conditional building blocks in Ericsson & Reneby (2003a) and the extra ones presented in the previous chapter. Chapter 4 investigates the effects of different capital structure specifications on equity option prices: we confirm Toft & Prucyk (1997) theoretical links by employing a more sophisticated model and also look at other usually neglected variables (e.g. debt growth rate) in the option literature; we also test the information content of structural models and find that even the simple Merton model is able to correctly rank firms according to their credit quality; we then investigate the relationship between CDS spreads and volatility smiles for an interesting example (France Telecom) extending the empirical analysis of Hull et al. (2005); in addition, we study an equity-credit hybrid security - an Equity Default Swap - and, its links with the more established Credit Default Swap. Chapter 5 presents a simple structural model with jumps - similar to Leland (2006) - which features closed formula for equity option prices. The final chapter concludes.