Option pricing theory and credit risk

It uses put-call parity to explain the credit risks of equity and bond holders in a company. Equity or stock is equal to a call bought on the assets A with face value of liabilities or bonds F as strike price. MV Bond is equal to default-free bond plus a put written on the assets A and with the face value of liabilities or bonds F as strike price.

The current value of the bond purchased by the bondholders who wrote the put is the difference between present value of a zero-credit-risk bond paying option pricing theory and credit risk coupons i. If option pricing theory and credit risk assets of the option pricing theory and credit risk are highthe put option expires worthless and bondholders get the entire face value of their loans back at maturity.

If the company gets into trouble credit related then the value of the assets will decline and the bond holders will get less at maturity i. In any case shareholders do not have to put up anything more. They already pledged the assets of the company in return for the loan.

They bought a put option at a cost reflecting the size of the assets and the size of the loan. Thank you for your response! But why the payoffs to the stockholders resemble those of a call option? They have the right to exercise the option - which since the call is out of the money - they do not exercise. The market short-sellers in stock market do that.

If the stock rises above the hurdlethe increased market value above the strike belongs to the shareholdershence the call option for shareholders. On the downsidethe shareholders are not the ones to pay the short-sellers when the stock falls.

The bondholders pay the short-sellers through losses on their loan. This is why it resembles a put option written by option pricing theory and credit risk holders. Skip to main content. Be prepared with Kaplan Schweser. AMA Mar 28th, With exam day right around the corner, Schweser's Final Review products are designed to help you finish out your study plan and walk into the testing center feeling prepared and confident.

I am very much confused! This model is called the Merton Model. You can find a lot of information about it on the web.

AMA Mar 29th, 8:

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