8/12/2019 Debt and Equity as Options

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Debt and Equity as Options

8/12/2019 Debt and Equity as Options

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Reviewing Put Options

Gives the holder the right to sell the underlyingasset S for a fixed price K on or before maturity T.

At time T if S>K the put holder would not exerciseand the option pay off is 0

At time T if S

8/12/2019 Debt and Equity as Options

3/10

Reviewing Call Options

Gives the holder the right to sell the underlyingasset S for a fixed price K on or before maturity T.

At time T if KK the put holder will exercise and theoption pay off is -S

T - Ke-rt

Pay off to the holder = Max (0, ST - Ke-rt)

8/12/2019 Debt and Equity as Options

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Zero Coupon Bonds

Value of Zero Coupon Bond with Face Value K

that matures at time T is Ke-rt

8/12/2019 Debt and Equity as Options

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8/12/2019 Debt and Equity as Options

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Debt and Equity as Options

Equity is a call option The underlying asset comprises the assets of the firm V

The strike price is the face value of the bond D

At time T if the assets of the firm are greater than thevalue of the debt (V>D)

The shareholders have an in-the-money call

They will pay the bondholders and call in the assets ofthe firm

Payoff to Shareholder = V-D

8/12/2019 Debt and Equity as Options

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8/12/2019 Debt and Equity as Options

8/10

Debt and Equity as Options

Equity is a put option.

The underlying asset comprises the assets of thefirm V

The strike price is the face value of the bond D

At time T if the assets of the firm are less than

the value of the debt (V

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Debt and Equity as Options

At time T if the assets of the firm are less than

the value of the debt (V

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Debt and Equity as Options

Payoff at maturity

if V>D

Payoff at maturity

If V