Chapter 3 Option-based

interpretation of corporate
securities
Quick review of options

▪ For more refer to any edition of John

Hull “Options, Futures and Other
derivatives” or recommended textbooks
for our course (e.g., Chapter 21 of Berk,
DeMarzo)

2
Motivation

❑ Most firms are protected by limited

liability
❑ Shareholders can loose at most their
capital, but have unlimited gains
❑ Debtholders can gain at most the value
of the debt (capital and interest)
❑ These payoffs (and their implications
for financing and investment decisions)
can be understood using option theory

3
 A. Call option

Shareholders
Gain for shareholders

D V
Value of the firm

Shareholders with unlimited Shareholders have limited

responsibility : V - D responsibility: Max (0, V - D)
4
5
Option-based interpretation of corporate securities

▪ 2 dates: 0 and 1. r = 10%.

▪ At t=0, consider a firm with Assets=100.
▪ Debt: Face value = 90, Maturity date: t=1
▪ No dividend payments (between 0 and 1)
▪ Random CF (130/70)

T=1 Good State Bad State

CF 130 70
Shareholders Debt payment = Bankruptcy
Decision 90
Shareholders CF 40 0 (limited liability)

➔ Equity = Call option on the assets of the firm. 6

Interpretation in terms of call option

❑ At t=1, the shareholders can choose between declaring

bankruptcy or buying the firm’s assets from the debt-
holders at the face value of debt.

❑ At t=0, this is a call option bought from the debt-holders

▪ Underlying = Assets
▪ Strike = Face value of debt
▪ Maturity = maturity of the loan
▪ Volatility = volatility of cash flows

❑ As if, at t=0, shareholders sell the ownership of the firm

to debt-holders and at the same keep a call option

7
Market value of equity

P A0 =
A1 +=130
PV(Future CF)
A0=100 = PV(CF1)
1-P A1-=70

A0 = (P*A1+ + (1-P)*A1-)/(1+r)
=>110= P*130+70-P*70 = P*60+70
→ P = 2/3
P E1+=A1-D = 40
E0=?
1-P E1-=0
E0 = [P*E1+ + (1-P)*E1- ] / (1+r)
→ E0 = P*40/1,1=24.4
8
 Now consider debt

Debt value at t=1

90
Debt value

70 90 130 CF1
Assets Value
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Debt Value = Risk free debt – Put Value
90
Risk free debt

70 90 130 CF1

Short Put Option

- 90
10
Debt Value = Risk free debt – Put Value
90

70 90 130 CF1

- 90
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Interpretation in terms of put option

❑ Debt holders have a risk free credit and sell a put

on the firm to shareholders
▪ Underlying = Assets
▪ Strike = Face value of debt
▪ Maturity = maturity of the loan
▪ Volatility = volatility of cash flows

❑ If value of the firm < K, shareholders exercise

the option (= do not pay back the debt ) →
debt holders retain the assets of the firm
❑ The payment of K from debt holders to shareholders is
equivalent to cancelling the debt

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 Summing up
Shareholders Debt holders

Interpretation in terms of call

Have a call on firm’s assets Own firm’s assets
Sold a call to shareholders

Interpretation in terms of put

Own firm’s assets Have a risk free credit of D
Debt D Sold a put to shareholders
Have a put on firm’s assets

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 Put-Call Parity and value of the firm

❑ For shareholders, the two approaches must be

equivalent:
❑ Value of Call = Value of asset – D + value of Put

❑ Also for debt holders, the two approaches must be

equivalent:
❑ Value of asset - Value of Call = D - value of Put

❑ Hence, put-call parity:

❑ Value of Call - value of Put = Value of asset –
PV(strike price)

❑ Market Value of Assets = C0- P0+PV(K) 14

Put-call parity example of a financial
option
▪ January 31, 2014
▪ Stock price of L’Oreal = 122
▪ Price of options on stock of L’Oréal,
exercise price =120
Maturity Buy - Call Sell - Put

February 21, 2014 4.68 2.67

April 17, 2014 6.74 4.68

December 19, 10.37 10.34

2014
Dcemebr 18, 2015 13.68 15.48
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Call-put parity - example
call – put = Stock Price – PV of Exercise Price
Call – Put = S – K e-rT ; If r = 0, call – put = 122 – 120 = 2
If r = 0.5% and dividend = 2.5 (payment in May)

Maturity Call Put Call - Put S - Ke-rT S – div -

Ke-rT
21/2/14 4.68 2.67 2.01 2.03

17/4/14 6.74 4.68 2.06 2.12

19/12/14 10.37 10.34 0.03 2.53 0.03

18/12/15 13.68 15.48 - 1.80 3.12 -1.88

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Valuing company’s equity as an option
- Example
▪ Company M has 1000$ of assets and
zero-coupon debt of 750m to be paid
back in a year.
▪ The value of M’s assets in a year will be
1600 with a probability of 0,6 and 625
with the probability of 0.4.
▪ Annual risk-free rate = 4%. Compute
equity value of the company M as an
option on its assets using:
▪ - one-period binomial model
▪ - Black and Scholes model
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 Binomial model

pFu + (1 − p ) Fd where p = [ 1+ r - d ]
F= u–d
1+ r
Where p is a risk-neutral probability
Value F follows Bernoulli process with a
probability p to reach the value of Fu by the end
of the period:

Fu = max(0, uS –K) Fd = max(0, dS –K)

Parameters u and d represent up and down

movements of the stock price
NB. The value of the option does not depend on the initial
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probability of the stock price to move up and down
Binomial model

Exercise price 750

Interest rate 0,04
Option maturity = 1 an
u = 1600/1000 = 1.6
d = 625/1000 = 0.625
p = (1+r –d)/(u-d) = (1.04-0.625)/(1.6-
0.625) = 0.425

Fu = 850 Fd = 0
Option value F= (850x0.425)/1.04 =347.3
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 Black and Scholes model

▪ S =1000 ; K = 750 ; r = 0.04 ; T = 1

Value of the call = N(d1)  S – N(d2)  K  e-T  rF
Relation bw parameters u,d and volatility (Cox, Ross et
Rubinstein)
 T /n
u = exp
where n is the number of periods in T
here, T=1, n=1,  = LN(u) = 0.47
Call
d1 d2 N(d1) N(d2) e(-rT) option
0,932 0,4622 0,8244 0,67802 0,96079 335,801

NB: compare to 347.3

for the binomial model
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Applications of option theory to
financing and investment
decisions

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 Recall

❑ Shareholders have a call option, debt holders have sold a

call option

❑ Call option value = intrinsic value + time premium

❑ Time premium increases with

❑ Maturity → shareholders may have interest to renegotiate the
maturity of debt in bad times
❑ Risk (volatility of assets) → shareholders may have interest to take
risk

❑ Possible conflict of interests between shareholders and

debt holders
❑ See also Chapter 2 on agency

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OPTIONS THEORY AND VALUATION OF
EQUITY

Example:
•Take a company financed by equity and debt
•Assume the value of debt is 100, redeemable in one
year
•If the firm value is 150 at the time of calculation,
the equity value will be (150-100) 50, as difference
between firm value and the value of debt
•Assuming a risk-free rate of 5%, and applying
options theory the discounted value of the debt +
interest payment (6%) at the risk-free rate is
(106/1.05)=100.95
• Value of debt = Value of debt at the risk-free rate – Value of a put option
24
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OPTIONS THEORY AND VALUATION OF
EQUITY
Value of the put option = 100.95 – 100 = 0.95
Then the value of equity split into
Value of equity = 50
– Intrinsic value (150-106) = 44
= Time value =6
•If we now assume that cost of debt is 15%. The
amount to be repaid in one year is 115
The discounted value of debt is (115/1.05) = 109.52
The value of the put is 9.52
The value of equity is still 50, but it breaks down into
intrinsic value (150- 115) 35 and time value (50-35)
15
25
25
OPTIONS THEORY AND VALUATION OF
EQUITY
•In the second example the value accounts for an
higher portion of the equity value
•The time value of an option increases with the
volatility of the underlying asset

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 Taking too much risk

▪ Holding Inc. holds 100 stocks of Girlie Inc. selling $2,230 each. The
enterprise value of Holdings Inc. is equal to the number of Girlie Inc.
shares multiplied by their closing price = $223 000
▪ Liabilities of Holding Inc. consist of 100 stocks and 300 zero-coupon
bonds with face value $1,000 to be repaid in 3 years from now.
▪ Call options on Girlie Inc. stock with a 3-year maturity have the
following characteristics:

Exercise price Premium

2,000 250
2,600 130
2,800 80
3,000 45
3,200 32

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Source: Vernimmen
The balance sheet of Holding Inc.

❑ Holding Inc.’s common stock = call option on the assets of

Holding Inc. with an exercise price of $3,000 each.
❑ According to prices given in the table above => Value of
equity = $45*100=$4,500

❑ Market value of the bonds outstanding: $223,000 – $4,500

= $218,500
❑ Implicit rate on the bonds:
218,500/300,000=0.726=1/(1+r)3 → r=11.2%

Holding Inc.(Market values)

Girlie Inc. 218.5 Bonds outstanding
(100 shares) 223 4.5 Common stock (100 shares)
Total assets 223 223 Total liabilities
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Source: Vernimmen
Taking risk and option value

❑ Suppose the shareholders of Holding Inc. sell the low-risk shares

of Girlie Inc., and simultaneously buy riskier stocks of Badboy
Inc.

Premium of a call option on the stock of Badboy Inc. with an

exercise price of $3,000 and a 3-year maturity: $140.

➔ What is the value of the common stock of Holding Inc.?

100 x $140 = $14,000 (a $9,500 increase)

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What is the value of the bonds of Holding Inc.?
$223,000 – $14,000 = $209,000 (a $9,500 decrease)

What is the implicit rate on debt?

300/(1+r)3 =209 → r=12.8%

If debt-holders are sophisticated, they anticipate this, and increase

the rate of return they demand on the debt, or refuse to lend
money to Holding Inc.

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 Renegotiating debt maturity

▪ As before, Holding Inc. has debt with face value of $300,000 to be repaid
in 3 years and 100 shares.

▪ Call options on Girlie Inc. stock with a 4-year maturity

Exercise price Premium

2,600 140
2,800 89
3,000 53
3,200 40

▪ New value of equity = $5,300 (increase of 800)

▪ New value of bonds = $223,000 – $5,300 = $217,700

(decrease of 800)

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Option theory and bankruptcy law
So far we assumed that debtholders were
able to claim firm’s assets in case of
bankruptcy
In reality, certain bankruptcy regulations
limit this possibility. Bankruptcy laws
vary from country to country.

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 34
British and German law is more protective of debtholders compared
to French or American law. Source : Davydenko et Franks, JOF2008
- Mortgage collateral is not often used in France, more individual
guarantees (shareholders’ responsibility is no more limited!)
- In the UK 1st class debtholders have the power of veto on
administrative decisions and can control the firm.
- In Germany: intermediate situation (debtholders have certian
power in the restructuring process) 35
36
To conclude

▪ Bankruptcy law that favors ongoing

concern (Italy, France, US – chapter 11)
preserves jobs. Employee contracts can
be renegotiated.
▪ Laws favorable to debtholders (UK,
Germany, Spain). Debt recovery rates
are higher
▪ Option approach to equity value is more
relevant in the context of bankruptcy
law with strong debtholder protection 37