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Could you be able to explain the following with an example? I’m not able to understand this clearly
Option pricing can be used to explain why companies facing severe financial distress can still have positive equity values. A company facing severe financial distress would presumably be one where the equity holders’ call option is well out-of-money
and therefore has no intrinsic value. However, as long as the debt on the option is not at expiry, then that call option will still have a time value attached to it. Therefore, the positive equity value reflects the time value of the option, even where the
option is out-of-money, and this will diminish as the debt comes closer to expiry.Buying a share in a limited company that had debt borrowing is like buying a call option. The reason is that if the company does well, then the debt can be repaid and what is left belongs to the shareholders. However if the company does badly and does not have enough to repay the debt, then they will close the company – the shareholders get nothing, but they do not have to pay in the missing money.
This does not happen until it comes time to repay the borrowing. So even if at the moment it looks as though the company will not be able to repay, there is always the possibility that by the time repayment is due things will have improved and they will be able to repay and shareholders will get what is left.
The longer the time period before repayment is due, the more chance there is of things being OK, and so the higher will be the share price (using Black Scholes formula). However as repayment gets closer and closer, the less chance there will be of things improving enough and so the share price will reduce.
How buying a share in limited company with debt borrowing is like buying a call option ? As i know call option is right to buy so can it be not put option ?
And please explain how bsop model and options are useful in determining the value of equity and default risk ? I read it several times but not getting anything ?
If you buy a share then you are buying the right to gain from the company doing well, but you are limiting the loss if the company does badly (because shareholders are not responsible for paying the debt lenders if the company goes bankrupt).
Please explain how bsop model and options are useful in determining the value of equity and default risk ?
Because the share is like an option, the value of the option using the formula gives a value for the share.
Within the BSOP model, N(d1), the delta value, shows how the value of equity changes when the value of the company’sassets change. N(d2) depicts the probability that the call option will be in-the-money (i.e. have intrinsic value for the equityholders).Debt can be regarded as the debt holders writing a put option on the company’s assets, where the premium is the receipt ofinterest when it falls due and the capital redemption. If N(d2) depicts the probability that the call option is in-the-money, then1 – N(d2) depicts the probability of default
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