Debt and Equity as Options

Reviewing Put Options

Gives the holder the right to sell the underlying asset S for a fixed price K on or before maturity T. 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 - ST Pay off to the holder = Max (0, Ke-rt - ST)

Reviewing Call Options

Gives the holder the right to sell the underlying asset S for a fixed price K on or before maturity T. 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 - Ke-rt Pay off to the holder = Max (0, ST - Ke-rt)

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

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, they will not pay the bondholders (i.e. the shareholders will declare bankruptcy) and let the call expire.

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. They will put the firm to the bondholders. Payoff to Bondholder = D-V

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, they will not exercise the option (i.e. NOT declare bankruptcy) and let the put expire. Payoff to bond holder = D

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