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Dear sir, The following is written in the latest Kaplan study text
” The Black Scholes model can also be used in debt valuation. The value of a (risky)
bond issued by a company can be calculated as the value of an equivalent risk free
bond minus the value of a put option over the company’s assets.
Therefore, if the value of equity has already been calculated as a call option over the
company’s assets , the value of debt can then be calculated using the put call parity equation.”I didn’t understand this at all. A student had asked the same query a year ago and you mentioned its not examinable…
Is it still irrelevant? If not irrelevant can you please explain this..
ThanksI have never written that it was not examinable or that it was irrelevant.
What I actually said was the you can be expected to explain the idea, but not to perform calculations!
See this reply to a previous question:
https://opentuition.com/topic/using-bsop-to-value-debt-and-equity/https://opentuition.com/topic/use-of-black-scholes-model-in-debt-valuation/?amp
If its examinable..can you pls explain..I didnt understand any bit of it
I do apologise – I sent you the wrong link 🙁
Here is the correct link and if you read my replies carefully then it should make sense (and is all you can be expected to know for the exam 🙂 )
https://opentuition.com/topic/using-bsop-to-value-debt-and-equity/
(I assume that you are happy with the idea of options in general (real options and share options) from my free lectures, and that you have covered the chapter in our lecture notes (and watched the lectures that go with them) on the valuation of mergers and acquisitions, which does cover the the using of BSOP for business valuation?)
I completely read the link you shared and know how BSOP is used for equity valuation…however it still doesn’t answer how BSOP is used for “debt” valuation.
(1) “The Black Scholes model can also be used in debt valuation. The value of a (risky)
bond issued by a company can be calculated as the value of an equivalent risk free
bond minus the value of a put option over the company’s assets.”
I get it why value of risky bond will be lower than risk free bond but why minus the put option…Like what’s the logic behind that(2)”If the value of equity has already been calculated as a call option over the
company’s assets , the value of debt can then be calculated using the put call parity equation.” Is is because debt holders have sold a put option as the company is sold to them for more than it is worth? Just to confirmKindly just emphasize on (1)
Oh dear – I realise that I misinterpreted your question 🙁
I am not sure that what you quote from Kaplan is actually correct.
Although I will be very surprised if the examiner asks about the valuation of debt using the BSOP model, if he ever did then the most he would expect is a theory (put forward by someone called Merton) that the value of the debt in a company is the value of the whole company less the value of the equity (the value of the equity being calculated using the BSOP model as you understand). Although that is in itself a pretty obvious statement, he did expand (particularly regarding the valuation of the whole company) but the expanding is far beyond anything that could be required in Paper AFM.
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