Debt and Equity as Options | Bonds (Finance) | Put Option

Debt and Equity as Options

• At time T if S>K the put holder would not exercise and the option pay off is 0 • At time T if S<K the put holder will exercise and the option pay off is Ke-rt .Reviewing Put Options • Gives the holder the right to sell the underlying asset S for a fixed price K on or before maturity T.ST) .ST • Pay off to the holder = Max (0. Ke-rt .

Reviewing Call Options • Gives the holder the right to sell the underlying asset S for a fixed price K on or before maturity T.Ke-rt) .Ke-rt • Pay off to the holder = Max (0. • At time T if K<S the put holder would not exercise and the option pay off is 0 • At time T if S>K the put holder will exercise and the option pay off is -ST . ST .

Zero Coupon Bonds • Value of Zero Coupon Bond with Face Value K that matures at time T is Ke-rt .

Debt and Equity as Options • In financial terms: – Bond holders hold a default free zero coupon bond and are short a put option on the value of the firm – Shareholders hold a call option on the firm • Firm issues debt with face value D at time 0. The debt matures at time T. .

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 the value of the debt (V>D) – The shareholders have an in-the-money call – They will pay the bondholders and “call in” the assets of the firm – Payoff to Shareholder = V-D .

they will not pay the bondholders (i.e. the shareholders will declare bankruptcy) and let the call expire.Debt and Equity as Options • At time T if the assets of the firm are less than the value of the debt (V<D) • The shareholders have an out-of-the-money call. .

Debt and Equity as Options • Equity is a put 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 less than the value of the debt (V<D) – Shareholders have an in-the-money put. – Payoff to Bondholder = D-V . – They will put the firm to the bondholders.

Debt and Equity as Options • At time T if the assets of the firm are less than the value of the debt (V<D) – The shareholders have an out-of-the-money put. NOT declare bankruptcy) and let the put expire. – Payoff to bond holder = D . they will not exercise the option (i.e.

Debt and Equity as Options Payoff at maturity if V>D Firm Value at time T Bondholder: Debt Put Option Shareholder: Call Option V-D 0 D 0 D -(D-V) V Payoff at maturity If V<D V .

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