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Why can equity in a troubled firm be viewed as a call option?

Why can equity in a troubled firm be viewed as a call option?

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Answer #1


Equity in troubled firm replicates the call option. The equity holders would get residual balance if the firm goes for closure.

Equity holders would get following:

Equity = Max (Present Value of firm - Present value Bond, 0)

Value of the firm behaves like stock price “S” and Value of Bond behaves like Strike price “X”.

Recall equation for Call option > C:

C = Max (S - X, 0)

C is like equity; S is like Value of the firm; X is like bond of the firm.

Hence, Equity in a troubled firm be viewed as a call option.

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