Class 17

Debt and Equity as

Options, Credit Risk
and Credit Default
Swaps

Today

• Corporate securities as options

▪ Equity: as a call option on the firms’ assets
▪ Debt: as a portfolio of options
• Credit Risk: risk of default by the issuer of a bond
▪ Credit Default Swaps (CDS)
▪ Risky debt: valuation, credit spreads over treasuries
and agency conflicts
• Course overview
▪ Main ideas
▪ Final exam

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Media

Media

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 DEBT & EQUITY

AS FINANCIAL OPTIONS

Real Asset Valuation as “Options”

Gen II A good outcome:

Tech exercise the option
to invest

$900

$463 A bad outcome:

Don’t exercise the
option to invest

0 1 2 3 Time

What are the Implications for

Capital Structure?
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Assets=Liabilities

Assets Liabilities

Market Value
of Debt
Enterprise
Value
Market Value
of Equity

Financial
Option
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Equity as a Call Option

• Equity is a residual claim: claim to cash-flows left over

after other claim-holders (debt, etc.) have collected
▪ Ex. Liquidation. Assets are sold, equity investors get whatever is
left over in the firm after the debt (& other claims) are paid off
▪ With limited liability (publicly traded firms): equity investors cannot
lose more than their investment in the firm.
• Equity as a Call Option:
▪ The equity in a firm can be thought of as a call option on the assets
with a strike price equal to the value of debt outstanding.
▪ Right to buy an asset at a pre-specified strike price
• If firm value < debt value: bankruptcy; equity gets nothing
• If firm value > debt value: equity holders get residual claim

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Equity as a Call Option
Example: firm with $50M in debt outstanding, due in 1 year
100

Firm value
75

50
Payoff

Call payoffs
= Equity
payoffs
25
To get the
assets, equity
must pay the
“bank”: $50M
0
0 25 50 75 100

-25
Firm value ($M), at maturity 9

Debt as an Option Portfolio

• Debt holders (or the bank): debt is economically

equivalent to the following portfolio:
▪ Buys: the firm
▪ Sells: a call option on the firm assets with a strike price equal to
the debt outstanding
• Payoffs:
▪ If firm value > debt payment: call is exercised. Debt holders:
• Receive the strike price and give up the firm
▪ If firm value < debt payment: call expires (worthless)! The firm files
for bankruptcy
• Debt holders get the firm’s assets

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Debt as a portfolio of options I

Example: firm with $50M in debt outstanding, due in 1 year

100

Firm value
75

Call
50
Payoff

Firm value
minus call

25

0
0 25 50 75 100

-25
Firm value ($M), at maturity 11

Put-Call Parity

• S + P = C + PV(K)

• C = S + P- PV(K)

• So if Debt is = S-C
= S-(S + P- PV(K))
Debt → PV(K)-P

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Alternative interpretation

• Debt payoffs are also comparable to the another portfolio:

▪ Buys: risk-free debt, and
▪ Sells: put option on the firm’s assets with a strike price equal to the
required debt payment

• Payoffs:
▪ Firm assets < debt payment: put is exercised!
• Put owner gets: Max(K-S,0), i.e. the difference between the required
debt payment (K) and the firms’ assets (S)
• Debt holder gets the firms’ assets!
▪ Firm assets > debt payment: put expires (worthless)!
• Debt holder receives the required debt payment: i.e. risk-free amount

Debt as a portfolio of options II

Example: firm with $50M in debt outstanding, due in 1 year

100

75
Risk-free
debt
50
Payoff

Risk-free debt
Put minus put
(i.e. -Max(K-S,0)
25

0
0 25 50 75 100

-25
Firm value ($M), at maturity 14

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Credit Default Swaps

• Insight: we can eliminate the credit risk in a bond (i.e. make it

risk-free) by buying a put option :

Risk-free debt = Debt + Put option on firm assets

• This put option is called a credit default swap (or CDS).

▪ CDS: buyer pays a premium to the seller and receives a payment from the
seller to make up for the loss if the bond defaults.

CDS México (5 años)

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Pricing Credit Risk

• So far, we have valued equity and risk-free debt

▪ Equity value = enterprise value – net debt, where debt is risk-free
• What if debt is not risk-free, i.e. risky debt?
▪ Credit risk: risk of default by the issuer of a bond
▪ The pricing of credit risk is important for:
• Evaluating financing terms: is the debt fairly priced?
• Valuing equity
• Option pricing methods can be used to value both equity
and debt in the presence of credit risk

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DEUDA / EQUITY

CAPITAL STRUCTURE AS OPTIONS

EXAMPLE

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Example: Corporate Securities as Options

• AMC Industries
▪ Currently a 100% equity finance firm
▪ Market capitalization = $100M = $40 per share  2.5 M shares
▪ Pays no dividends
▪ Implied volatility of AMC stock = 40%
• AMC is considering adding leverage
▪ Issue $60M face value of 5-year, zero coupon bonds
▪ Use proceeds from the bond to pay a special one-time dividend
▪ For simplicity, assume perfect capital markets
• i.e. assume the MM conditions hold: no tax consequences, etc.

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Example: AMC Industries

• Questions:
1. What interest rate (yield to maturity) will AMC have to promise to
pay to investors in these risky bonds?
• How does this rate compare to the 5-year risk-free rate of 6% (EAR)?
2. How much money will AMC raise by issuing the bonds?
3. How risky is AMC’s debt? How risky is its levered equity?

EAR=Effective annual rate

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 The Possibility of Default

• Case 1. AMC’s unlevered equity: Value in

▪ Without leverage: the market Yr 5
value of the equity and the ($M)
market value of the firms’ assets 140
AMC AMC Assets
are identical Defaults = Unlevered
• Case 2. AMC’s levered equity: 120
Equity

▪ 60M in face value, to be repaid in

5 years 100
a. If the firm is worth more than
$60M, the debt will be repaid 80
Face Value
• With perfect capital markets, of Debt
AMC can refinance the debt, or 60
issue equity
b. If the firm is worth less than 40
$60M, AMC will default
20

0
0 20 40 60 80 100 120 140
Value of AMC Assets in Year 5 ($M)

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Levered Equity

• Payoffs: equity holders receive Value in

▪ If AMC is worth more than $60M, Yr 5
($M)
they repay the debt; shareholders
AMC AMC Assets
get the residual value 140
Defaults = Unlevered
▪ If AMC is worth less than $60M, Equity
120
AMC defaults; debt holders get
the value of assets
100 Levered
• Again, levered equity is a Call Equity
Option on AMC’s assets! 80
$60M

▪ In exchange for paying off the

60
debt holders in full, equity gets to
keep the firms’ assets
40
▪ Alternatively, equity holders can
default and give up the assets to 20
the debt holders
0
0 20 40 60 80 100 120 140
Value of AMC Assets in Year 5 ($M)

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 Risky Debt

• What will debt holders receive? Value in

Yr 5
▪ They are fully repaid, unless ($M)
assets are worth < $60M AMC AMC Assets
140
▪ If the assets are worth < $60M Defaults = Unlevered
Equity
debt receives the value of the 120
assets
100 Levered
Equity
• The combined value of debt and 80
equity equals the full value of
the unlevered assets 60

40
Equity + Debt = Unlevered Assets Risky
Debt
20
▪ We know this from M&M
• We are ignoring costs of 0
financial distress 0 20 40 60 80 100 120 140
Value of AMC Assets in Year 5 ($M)

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Option Interpretations of Risky Debt

• Assets = Equity + Debt Value in

 Debt = Assets – Equity Yr 5
($M)
▪ Given that equity is a call option: 140 AMC Assets
Debt = Assets – Call = Unlevered
Equity
120
• Alternatively, by put-call parity:
Debt = Assets – 100
(Assets + Put – Risk-free Debt) Call
80 Option
Debt = Risk-free Debt – Put
60
• Equity holders right to default is like a put
option on AMC’s assets Put
40
Option Risky
▪ They can turn over the assets of the firm Debt
to debt holders and clear their liability 20

▪ Exercise price = face value of debt ($60M)

0
0 20 40 60 80 100 120 140
Value of AMC Assets in Year 5 ($M)

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 DEBT & EQUITY

AS OPTIONS

VALUATION OF DEBT AND

EQUITY

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Valuing Levered Equity

Black-Scholes Option Price

• We can value levered equity 120
CALL
as a European Call option using BLACK/SCHOLES PRICE (a) 60.8563

Black-Scholes. 100

▪ Stock price = market value of

firm assets 80
▪ Strike price = face value of debt
60.86
60
Option Parameters
Asset Price 100 40
Strike Price 60
Interest Rate 6% (EAR) 20
Dividend Yield 0%
Volatility 40%
0
Expiration 5 Years
0 20 40 60 80 100 120 140
AMC Asset Value ($M)

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Valuing Risky Debt

Black-Scholes Option Price

• Debt value is therefore: 120

▪ Debt = Assets – Equity

= 100 – 60.86 100

= $39.14 million
• Alternatively, we can value the 80

debt as risk-free debt, less the 60.86

“default put option” 60

▪ Risk-free bond
= 60/1.065 = 44.83 40

▪ Less put option = -- 5.69

5.69
▪ Risky Debt = 39.14 20
5.69

0
0 20 40 60 80 100 120 140
AMC
AMC
Asset
Asset
Value
Value
in 5
($M)
years

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DEBT

CREDIT SPREADS/DIFERENCIAL
DE TASAS

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Credit Spreads over Treasuries

• Thus, issuing 5-year, zero-coupon bonds with a $60M

face value will allow AMC to raise $39.14 million today
• The initial yield-to-maturity is:

▪ This YTM > 6%, the risk-free rate

▪ Why? The risk of default!
• Credit spread = 8.92% - 6% = 2.92%

EAR=Effective annual rate

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Credit Spreads over Treasuries

Black-Scholes Debt Valuation s = 60%

40%
• The risk of default,
and the credit spreads 35%
s = 40%
increase with:
30%
▪ the volatility of the firm’s
assets and
Yield to Maturity

25%
▪ the amount of debt
issued 20%
• Example 2: s = 20%
13.87%
▪ Asset volatility 20% 15%
▪ Call value = 55.59
▪ PV debt=100-55.59=44.41 10% 8.92%
▪ Yield=(60/44.41)^(1/5)-1=6.2% 6.20%
▪ Spread=0.2% 5%

0%
0 20 40 60 80
Debt Amount (Present Value)

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Agency Conflicts

• Options provide another interpretation of agency conflicts

▪ Example 1. Risk-taking incentives
• Equity: call option; benefits from risky investments
• Debt: risk-free minus a short put option; gets hurt by an ↑ in volatility
▪ Example 2. Debt-overhang:
• Investment in NPV>0 projects, increase firm value
• With risky debt, NPV>0 investments:
➢ Put value declines: the firm is less likely to default
➢ Increase debt value: some fraction of the increase in the value of assets
goes to debt holders
➢ Can lead equity to pass on NPV>0 investments!!! (underinvestment)

Summary

• Equity and debt can be analyzed from the perspective of

financial options
▪ Equity: call option on the firms’ assets
▪ Debt: firms’ assets minus call with strike = required debt payment or
risk-free debt minus put option with strike = required debt payment
• Credit default swap: put that provides protection against a
credit event
▪ Ex. make corporate debt risk-free
• Credit spread or yield spread: the difference in yield
between different securities, due to different credit quality
▪ The firm must continually reevaluate its investment opportunities,
including the options to delay, abandon and expand projects

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 COURSE OVERVIEW

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Corporate Finance as a mode of thinking

• Corporate finance is a set of decision-making tools

• How can I achieve the best possible outcome with the limited resources I
have?
• Incredibly useful whenever resources are scarce
• Tools that help us assess costs and benefits
• Tools that force us to reveal our implicit assumptions
• Tools that discipline us and protect us from our own biases

• Corporate finance is a mode of thinking

• … rather than just a collection of formulas and spreadsheets
• The world is too complex to apply the tools mechanically
• Instead, use the frameworks of finance to organize your thinking

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Beyond Formulas… Logic and Learning

• Formulas:
▪ Example: given assumptions → compute a price

• Learn from markets:

▪ Given one price → identify the implicit assumptions
▪ Given two prices → identify opportunities
▪ Give behavior → assess whether it is optimal?
✓Is there money on the table?
✓Suggest ways to improve outcomes!

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Focus on the bottom line: Cash flow

• Be absolutely clear what your bottom-line objective is
• In finance, it is usually cash flow
• But finance tools are also useful with very different objectives

• If you have not analyzed a deal enough to write down its

bottom-line cash flows, you have not understood it
• The “other side” has every incentive to shift your attention to aspects
of the deal that look favorable to you
• Interest payments, principal payments, bonuses, EPS, cash-back, etc.
• Do not fall for it

• In corporate finance, the bottom line is Free Cash Flow

• What is left over each period after everything is said and done
• FCF can be taken out and invested elsewhere or paid to investors

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Free cash flow

• Think incrementally: compare the world if you take the

project against the world if you don’t
• Count only cash flows that are caused by the project you
are evaluating, but count all of them
• Always ask: would a cash flow still occur even without the project?
• If yes, it is not incremental to your decision, and you should ignore it
• Ignore sunk costs
• Ignore any other cash flows that your decision does not affect

• Account for cash flow effects of your project elsewhere in the firm
• Account for changes in the timing of cash flows
• Pay special attention to the cash flows at the end of your project
• Abandonment costs, liquidation proceeds, etc.

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Valuation
• Main valuation methods: (1) comparable or multiple-based,
(2) fundamental valuation, (3) no arbitrage valuation

1) Valuation by comparables or using multiples!

▪ Apply observed valuation multiplies of comparable firms (projects) to
your firm (project)
▪ Advantages:
• Easy: no need to estimate cost of capital, growth rates, profit margins, etc.
• Reflects current market conditions
▪ Disadvantages:
• No way to use your knowledge of the firm (project)
• Relies on other firms being correctly valued
• Good comparables are often hard to find

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Valuation

2) Fundamental valuation
▪ To value a firm or project
• Determine its FCF
• Make the FCF comparable by calculating their present values
• Compute the present values using your opportunity cost of capital

▪ The two main drivers of firm (project) values are

1. FCF and their projected growth path
2. Cost of capital

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Valuation

3) Replicating portfolio approach

▪ To value a project or a financial security:

1. Determine its cash-flows

2. Set a replicating portfolio that has identical cash-flows
3. Determine the price of the replicating portfolio

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Projecting growth
• When making growth forecasts, it is crucial to be both
realistic and internally consistent
• E.g., do not assume your firm grows faster than its industry forever
• What drives earnings growth?
Earnings Sales
Earnings =   Assets
Sales Assets

 Net Profit   Asset 

=     Turnover   Assets
 Margin   
▪ Earnings growth can come from increased sales profitability (net profit
margin) or asset efficiency (turnover)
• These cannot improve forever
• Long-term growth must come from investment in new assets
▪ When forecasting long-term growth, ensure it is supported by
sufficient investment into new assets
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Cost of capital (for a firm or project)

• Cost of capital: the return that investors require to be willing

to hold the firm (project) in their portfolio
• In practice, determined as an “opportunity cost of capital”:
• What investors could earn by investing into an equivalent marketable
security with the same risk as the firm (project)

• The right measure of risk is again the covariance (beta) of the

firm (project) with investors’ portfolios
• The CAPM assumes that all investors hold the market
• This makes the covariance (beta) with the market the right measure of
risk for any investment
• Opportunity cost of capital = expected return on a portfolio of
treasuries and the market with the same beta as the firm (project)
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Funding your firm (or project)

• Firm value is mostly determined by the cash flows

produced in the firm’s operations
• All we do on the right-hand side of the balance sheet is selling these
cash flows off to different investors
• This makes it difficult to create significant value on the right-hand side
of the balance sheet

• If there are no frictions, then it is impossible to create value

on the right-hand side of the balance sheet
▪ No Taxes, No Bankruptcy Costs
▪ No Agency Costs
▪ No Asymmetric Information
▪ Securities are fairly priced

• This is the Modigliani-Miller theorem

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Funding your firm (or project)

• In the real world, there are frictions

• Sometimes they are large and important, sometimes not

• But the M&M intuition continues to hold:

• Capital structure affects value if and only if it affects cash flows
• To increase firm value through a capital structure move, you need a
cash flow story
• This cash flow story has to be based on exploiting a market imperfection

• M&M is an incredibly useful roadmap for creating value on

the right-hand side of the balance sheet
• It also protects us against bogus (i.e., not friction-based) motivations
for capital structure moves

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The (extended) trade-off theory

• Trade-off theory of capital structure: Firms should choose

an optimal level of debt financing that balances:
1. Tax benefits of using debt financing
2. Agency benefits of debt (e.g., disciplining managers)
3. Low asymmetric information costs of debt
Against:
1. Expected costs of financial distress and
2. Agency costs of debt (e.g., excessive risk-taking, debt overhang)
• Optimal Capital Structure
▪ Increase leverage as much as possible to capture tax benefits, but not
so much as to incur large distress or agency costs

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Risk management

• Risk management allows firms to move cash flows between different

states of the world
▪ Goal: Transfer cash from states where we don’t need it to states where we do
• Always be clear about:
▪ What is the friction that makes risk management valuable?
• To justify hedging, you need a cash flow story

• Not hedging is always an alternative

▪ Fully hedging all risks is almost never desirable
▪ Hedging can incur significant transaction costs
• Hedging is about risk management and not about speculation
▪ Always remember:
• The people selling you the hedge are professionals and likely better at
forecasting the future than you
• Hedges are supposed to lose money about half the time

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Financial options

• Options give the holder the right but not the obligation to
take some action
• Main insight: Flexibility and downside protection can be very
valuable
▪ The one-sidedness of options turns volatility (risk / uncertainty) from
something bad into something good
• Option values are increasing in volatility
• Option holders have an incentive to increase volatility
➢ Executive stock options: counterbalance managerial risk aversion
➢ Equity as a call option on firm value: increase risk at expense of lenders

• Valuation: no arbitrage using replicating portfolio approach

▪ Binomial, Black-Scholes…

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Real options

• Real options: Management can change investment

decisions as new information arrives
▪ Only valuable future opportunities are pursued, bad ones
abandoned
• Real options require:
▪ New information (value-relevant) has to arrive over time
▪ New actions: management must have the ability to change the project in
response
• Optionality is incredibly widespread in managerial (and
personal) decisions
▪ Option to delay, to expand, to abandon

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Option logic

• Few projects would be started if there were no opportunity to

subsequently abandon (or expand)
▪ The same is true for professional and personal relationships
• Crucial: create your own real options by staging your
investments
▪ Invest just enough to move the project forward and learn more about its value
▪ Abandon or expand the project based on the new information learned
▪ Push large investments forward as long as possible until the uncertainty is
resolved
• Make the option logic part of your mode of thinking!
▪ Equity, debt, etc. as financial options
▪ Incredibly useful

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FINAL EXAM

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Final Exam: Format
I. Comprehensive: every class
I. Use main conceptual idea from each class; apply it in practice
II. Start with the second half: financial options; real options
III. Length approx.: 150 Minutes (2 hours and a half)
II. Can bring a “formulario” (one-page/two sided)
I. Formulas to solve problems: compute X and Y
II. Use reality to learn about finance (prices to formulas)
III. Be ready to make recommendations: decisions!
III. Practice: “active / not passive” learning strategy
I. Explain the main ideas to others
II. Study guide under time constraints; without looking at solutions
III. Practice exams in “pairs” of questions (2 questions at one time);
consider “alternative questions”

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