It is said that the equity holders of a levered firm can be thought of as holdin

Question

It is said that the equity holders of a levered firm can be thought of as holding a call option on the firm's assets. Explain what is meant by this statement.

One thing put-call parity tells us is that given any three of a stock, a call, a put, and a T-bill, the fourth can be synthesized or replicated using the other three. For example, how can one replicate a share of stock using a call, a put, and a T-bill?

An insurance policy is considered analogous to an option. From a policyholder's perspective, what type of option is an insurance policy? Why?

Explanation / Answer

1

The equity holders can be thought of as holding an option on the total value of the firm. The debt is represented by zero coupon discount bonds payable entirely at maturity. At maturity, equity holders can exercise their option by paying off the debt, thereby realizing the total value of the firm less the exercise price of the option. The latter is simply the face value of the debt. If the total value of the firm is less than the face value of the debt, equity holders will elect not to exercise their option, and the value of their stock will be zero. Debt holders will own the firm, but its total value will be less than the debt's face value. With an option, of course, an increase in the volatility of the underlying asset results in an increase in the value of the option, whereas a decrease in volatility results in a lower value of the option, all other things staying the same. In this case, the underlying asset is the total value of the firm, so a reduction in its variance will result in a lower value of the option, as represented by the value of the stock. On the other hand, reduced volatility, which may occur with a merger, works to the advantage of the writer of the option, so the value of the debt should increase.

If this line of reasoning holds, equity values should decrease with mergers, whereas debt values should increase. However, Higgins and Schall suggest that this can be prevented if the pre merger debt is retired at its pre merger market value." In this case, equity holders would not suffer any loss in value with a merger, as debt would later be reissued at a higher post merger value. Kim and McConnell suggest that the same thing can be accomplished by the firm's increasing its financial leverage to the point where the increase in the post merger default risk of the previously outstanding debt just cancels any wealth transfer that might occur from equity holders to debt holders."

Essentially, equity holders protect themselves against an erosion in the value of their claim by imposing restrictions on the company. These restrictions frequently are called "me first" rules. Their purpose is to protect debt holders and equity holders against financial policy changes that work to the detriment of their respective wealth positions. In summary, the option pricing model argument implies that diversification does not change the total value of the firm, although there can be a redistribution of value between equity holders and debt holders)

2

Put/call parity is a captivating, noticeable reality arising from the options markets. By gaining an understanding of put/call parity, one can begin to better understand some mechanics that professional traders may use to value options, how supply and demand impacts option prices and how all option values (at all the available strikes and expirations) on the same underlying security are related. Prior to learning the relationships between call and put values, we

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