CFAI Online Exam Qtn - Debt

Question #8 Answer: Debt of a company can be modeled as a long position in a risk-free bond and a short position in a put option. Can someone explain further? Or Where in Schweser or CFAI can i get more content about this concept? Thanks,

it’s not in Schweser, I believe it was in the introduction to application of derivatives for risk management. It’s a very long introduction , you can’t miss it.

It seems like it’s an extension of the “Creating Equity out of Cash” section in SS13, but I would have thought that rather than short a put (don’t get that one?), it would have been long futures??

All the other options didn’t make sense to me, the only thing I remembered from this 5 page discussion is that when company declares bankruptcy, the lenders take the asset of the firm, whatever their value is at the time, which is similar to a short put from their perspective.

in addition it’s like they are long a risk free bond because they (the bank) receive payments on regular basis

ya mo34 hits on it. think of it this way. you own the stock of a firm right. do you have limited liability? Of course you do because if sh*t hits the fan, you have the right to sell the firm to the debt holders. This is equivalent to being long a put. so if you’re a bond holder, you have implicity sold a put option to the equity holders leaving you with a long bond and short put on the firm.

Simple way to look at it, is your credit bond has higher yield, where do you get this yield? from writing a put :slight_smile:

What reading is this?

CFAI V5 p. 44-46