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Kindly explain why zero coupon bond is so special:
“For the exercise price, the debt of the company is taken. In its simplest form, the assumption is that the borrowing is in the form of zero coupon debt, i.e., a discount bond. In practice such debt is not used as a primary source of company finance and so we calculate the value of an equivalent bond with the same yield and term to maturity as the company’s existing debt. The exercise price in valuing the business as a call option is the value of the outstanding debt calculated as the present value of a zero coupon bond offering the same yield as the current debt.”Zero bond means there is only time value i.e discounted to get present value….means only bond value is discount and no interest payments.,,,,,in simple words bond has no periodic interest payments
Now come to BSOP:
1) While calculating price price we calculate MV of company’s bond (PV interest+redemp)
2) So we assume debt to be zero coupon bond and find redemption value at maturity by “compounding” at discount rate the obtained MV of bond…..That’s part of bond in valuing firm by Real Option (BSOP)
I did a question, “AggroChem (Jun10)”. It is not compounding, but discounting.
Yessss I did the same and question has specifically said to do like this otherwise in article its compounding…………….so we have see question also for exception
Why we discount the debt of the company for using as Exercise price in valuation the company using BSOP Model, despite the fact that {e^(-rt)} in the BSOP formula is the built in discount factor discounting the Exercise price. Isn’t it double discounting of the exercise price?
Confused :(. kindly clarifyTutor, kindly help. I am also blur. “AggroChem (Jun10)” says discounting, SAnov09 says compounding. So what on earth is it, pls? Thank you.
I understand the problem you have! This question was set by the examiner who was sacked soon after, and it is very confusing.
However, despite everything you have written, and despite it being very strange, the question does say that the exercise price is to be taken as the present value of a zero-coupon bond with the same yield. It is very true that if it was zero-coupon there there would be a big premium on repayment (which is why you were wanting to compound), but he has ignored this (and there is no choice because there is not enough information) and so he has simply discounted the 3M at the yield.
Do not make things more complicated than they are.The new examiner sets hard exams, but at least they are more logical!!
I am sorry but I really cannot help more than that – it was a very unsatisfactory question (as were many that were set by that examiner).
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