Options on Leveraged Equity with Default Risk
AbstractIn this paper, I derive option pricing formulas for call and put options written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The firm can be forced into bankruptcy by breaching a net-worth covenant, or it may declare bankruptcy when it is optimal for equity holders to do so. Consequently, option values and sensitivities depend on structural variables such as the corporate tax rate, the firm's coupon payments, and the firm value at which bankruptcy is declared. The derived formulas for calls and puts on equity with default risk simplify to Black-Scholes type formulas for down-and-out barrier options if bankruptcy is declared as soon as the value of the firm's assets equals the after-tax value of the promised coupon payments on the debt. If the capital structure contains no debt, the pricing results simplify to Black-Scholes formulas for call and put options. The model developed in this paper relates implied Black-Scholes volatility for equity options to structural characteristics such as leverage and the debt's protective covenants. Options priced by the proposed model are characterized by Black-Scholes implied volatilities which are decreasing in striking price. Moreover, equity options on firms with protected debt have more pronounced volatility skews than options on firms with unprotected debt. Finally, I show how to evaluate the term structure of default spreads for corporate interest-only strips.
Download InfoTo our knowledge, this item is not available for download. To find whether it is available, there are three options:
1. Check below under "Related research" whether another version of this item is available online.
2. Check on the provider's web page whether it is in fact available.
3. Perform a search for a similarly titled item that would be available.
Bibliographic InfoPaper provided by University of California at Berkeley in its series Research Program in Finance Working Papers with number RPF-238.
Date of creation: 01 Jul 1994
Date of revision:
Contact details of provider:
Postal: University of California at Berkeley, Berkeley, CA USA
Web page: http://haas.berkeley.edu/finance/WP/rpflist.html
More information through EDIRC
Postal: IBER, F502 Haas Building, University of California at Berkeley, Berkeley CA 94720-1922
You can help add them by filling out this form.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum).
If references are entirely missing, you can add them using this form.