Credit Analysis Models - Structure model - option analogy

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Sanjay Sachdev

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Fixed income - credit analysis models - structure model - option analogy

The expression for the value of a company’s debt (viewed in its entirety) equates the
position of the company debt holders to holding a riskless bond that pays K with certainty at time T,
and at the same time selling a European put option on the assets of the company.

If the value of the assets is greater than the face value of debt, the put option will be out of the
money (and therefore, not be exercised) - what if call option holder exercises it - As, Assets > FV of debt(bond) doesn’t call option holder excersise it ?
 
Yes.
If the company does well, the owners exercise the option (to stay in business) and pay off the debt.
If the company does poorly, the owners let the option expire: they liquidate the company and the debtholders are stuck with the loss.
 
Great! now, what if the situation is vice versa..i mean when European put option is in the money ? what will be the payoff to debtholder?
 
That’s when the company does well. The option’s in the money, so they pay off the debt holders (according to the terms of the debt).
 
I got it. i wish if i could be full time student of yours!
Thanx a lot Sir!!!
 
S2000magician wrote:
Yes.
If the company does well, the owners exercise the option (to stay in business) and pay off the debt.
If the company does poorly, the owners let the option expire: they liquidate the company and the debtholders are stuck with the loss.
Click to expand...
Shouldn’t it be the other way round (from memory)? If the company does poorly, then the option holders exercise the put option at the strike price (equal to the face value of debt) to pay it off? On the other hand, if the company does well, then the holders of the option let it expire and pay off the debt from cash, while the option writers earn the RFR plus the credit premium in the form of the option price sold? That’s how I understood it.
 
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