Credit Risk Reversal (CRR), a market model for relative Credit/Equity Volatility pricing and hedging, corrected the short-comings of structural Merton-style debt-equity models and resulted in a range of credit “bear” products for funds and bank loan portfolios.
The strategy became a landmark in Debt-Equity trading and was acknowledged as one of JPMorgan’s achievements for IFR “Derivatives House of the Year” 2003 award.
CRR has become a popular model for constructing credit-equity relative value trades as well as useful tool for asset allocation and risk management. The model has been used by leading global banking institutions including JPMorgan, Deutsche Bank, Morgan Stanley and Credit Suisse.
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.
