Created by Dr. Jan-Frederik Mai

The risk reversal trade on insolvent firms

After a heavily indebted company has filed for bankruptcy, its stock price typically drops significantly and enters a new regime. On the one hand, the stock price is expected to approach the value zero eventually, since the remaining firm value is ultimately distributed among its creditors with minimal leftovers for equity owners. On the other hand, until a negligible stock price level is attained, speculative trading can lead to high volatility and even extreme upward spikes. Recent examples for such situations are the stock prices of Hertz Global Holdings Inc. and Wirecard AG. A bullish risk reversal trade is one possible alternative to an outright stock purchase that speculates on such a spike. Similarly, a bearish risk reversal trade is one possible implementation to technically short-sell the stock. In both cases, the essential profile implemented by the risk reversal trade mimics that of an equity forward, with the sole distinction that typical put and call options in the marketplace are American-style. The essential risk is whether the involved options expire before or after the stock price has arrived at an absorbing state of negligible value. In order to assess the risk reversal’s attractiveness traders thus need to compare their own subjective opinions regarding the equity forward with those implied by the observed put and call prices. The task of backing out the equity forward from American-style prices is a non-trivial numerical challenge in general. The present article introduces a method to compute model-free lower and upper bounds on the equity forward that are sharp, i.e. attained by some arbitrage-consistent models.


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