Question

For a levered firm, firm’s assets are financed by equity and debt. That is, ?? = ?? + ?? , where ?? ,?? & ?? represents asset value, debt value and equity value at time ?. Suppose the firm makes no dividend payment and has a zero-coupon debt maturing at time ?. At maturity, if the value of the company asset is greater than the maturity value of the debt (?? > ??), the company will simply pay off the debt. Otherwise, the company will declare bankruptcy and debt holders will own the firm. Part (a): At maturity ? = ?:

(i) From an equity holder perspective, describe a company’s equity as a call option. In your answers, identify the underlying asset, strike price, maturity, and the payoff function of the call option.

(ii) From a debt holder perspective, describe a company’s debt using a call option. In your answers, identify the positions that the debt holder takes on each asset (i.e. long or short?).

Answer 1

(i) It is better for equityholder to exercise the call option if current market price as on expiry>stike price.here equity  is underlying asset. stike price will be the price at which option will be exercised. Pay Off function will be net profit earned if option is exercised calculated as Pay Off Function =CMP as on expiry-strikeprice-option premium paid. The specified time during which call option is sold is called time to maturity

(ii) A call option in debenture is a contract that  gives the right to debentureholder to buy the debenture by a particular date at particular price. The option is exercised by issuer if interest rates declines as it will result in increase of debentures price. A long position can be taken by debentureholder when they expect that underlying price will increase significantlyin the near future. The Short position will be taken when the prices are expected to decrease in future and this will be taken by selling all the debentures now and buying at lower rates in future