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John,
In term of concepts, I do not work out how BSOP could be employed to value the business although i could understand that the Debt holder sell the call option to shareholder as Premium is the Shareholder capital, the Underlying assets is the Business value, and the Exercise Price is the Outstanding debt, time to expiry is the time to due date of debts, the volatility is the changes of business value, pls. correct me anywhere I am wrong
The issues is that how an option value could help to value the business and in which ways?, pls clarify
Much thanks
If this is ever asked in the exam by the current examiner it will almost certainly be a question of just explaining the idea without doing calculations.
The idea behind it is as follows:
Provided the business is doing well, the benefit of the increase in the value of the company goes to the equity. However, if things go badly and the value of the company falls, then the amount that the equity suffer is limited. Once the value fell to be equal to the amount owing to the debt, the equity would not suffer any further losses because they would close down the company. The equity can’t go negative – and so the amount of they can lose is limited. That is what makes it like an option.
Again, I am pretty sure that that is as much as the current examiner would require if he were to ask it. If (and I think next to impossible) he did ever require any calculations, then I am certain that he would help you through it and tell you within the questions what you needed to do.
Can i know , why the BSOP model for equity valuation assume that it is an call option?
It is because just like a call option on shares, if the price goes higher then we gain whereas if the price goes lower we do not lose.
Hi John, are you aware of any past exam questions on the above application of BSOP on debt securities such as convertibles, callables? I am curious how else BSOP is examined other than real options.
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