Corporate Finance Question: Equity/Call Option Debt/Option Portfolio
Hey Monkeys,
Got the bad luck of having a corporate finance prof that has not taught the course before, and has never worked in Finance... Looking for some help on this question:
We are currently doing options, and I am having no problems with the basic concept of options, payouts, etc. However, at the end of the chapter, the textbook states that a share of stock is essentially equal to a call option on the assets of the firm, with a strike price equal to the value of debt outstanding. This makes sense to me...
I am having trouble grasping the concept of "debt holders owning the firm and having sold a call option with a strike price equal to the required debt payment"
OR
Risky Debt = Risk-Free Debt - Put Option on Firm Assets
Sorry if this is somewhat unclear/not very concise. If anyone has any pointers or insights on the topic, it would be much appreciated.
Thanks all!
Check out the below and let me know if that helps in any way. If not, I'll attempt to break it down for you:
"If the value of the firm exceeds the required debt payment, the call will be exercised; the debt holders will therefore receive the strike price and give up the firm.
If the value of the firm does not exceed the required debt payment, the call will be worthless, the firm will declare bankruptcy, and the debt holders will be entitled to the firm’s assets."
Source: University of Colorado Boulder
Is that where you go?
Thanks ddp34.
It just clicked in my head after reading your explanation, thanks a lot.
However, I am still unclear on the Risky Debt = Risk-free debt - put option on firm's assets?
And no, that isn't where I go to school!
Haha, okay sorry.
Do you know what put-call parity is?
Selling a put means getting paid something for incurring all of the downside risk of the asset below the strike price. Bonds are priced off of a spread to Treasuries (or whatever risk free asset in your home currency). Assume that Treasuries can't default, so there is no possibility of loss at maturity. If you buy a risky bond and it defaults, you lose everything less the amount you recover from the sale of their assets. The most you can recover is face value, everything above that goes to equity holders (almost always zero). So, think of your credit spread as the amount you get paid for selling a put with a strike equal to face value.
Or, rewriting the equation, if I buy a risky bond and hedge out all of the credit risk, I should be left with Treasury yields. Risky bond + Put Option = Risk free bond
At least, that's how I think of it.
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