Implicit Options and Games between Debtor and Creditor with Credit Derivatives

In contrast to previous researches on credit derivatives starting from credit risks, this paper examines default risks affected by the credit derivatives. The linkage of default risks and credit derivatives lies in the implicit options existing in the debt relationships. These options can also be changed if credit derivatives are introduced into the debt relationships, e.g., hedge the default exposure with credit derivatives. Firstly we show that it is optimal for creditors with both safety covenant and CDS protection to enforce early bankruptcy under certain conditions. This result suggests that other not fully hedged default risks can be more likely to enforce bankruptcy. The framework to inspect tradeoffs between credit derivative costs and expected payoffs is borrowed to study strategic debt service (SDS). Credit risks associated with SDS games between debtors and creditors with and without credit default swap (CDS) hedge are compared, and strategies are suggested to debtors and creditors respectively when CDS can play an important role in determining default or not. The capital structure arbitrage in the credit market is also discussed