Debt Option Analogy- Reading #38 pg 297

[girl1555]

So there is this statement given in CFAI text in Reading #38 pg 297

“The debt option analogy explains why risky debt is less valuable than riskless debt. The difference in value is equal to the short put option’s price. In essence, the debt holders lend the equity holders K dollars and simultaneously sell them an insurance policy for K dollars on the value of their assets. If the assets fall below K, the debt holders take the assets in exchange for their loan. This possibility creates the credit risk. ”

What I need to know is:

• Which risky debt is the CFAI talking about? Is it the debt that the lenders/bondholders have lent to the equity holders?
• Also what is the riskless debt here?
• Please also explain the relation of the difference between the riskless and risky debt with the short option put’s price.

[S2000magician]

@girl1555

So there is this statement given in CFAI text in Reading #38 pg 297

“The debt option analogy explains why risky debt is less valuable than riskless debt. The difference in value is equal to the short put option’s price. In essence, the debt holders lend the equity holders K dollars and simultaneously sell them an insurance policy for K dollars on the value of their assets. If the assets fall below K, the debt holders take the assets in exchange for their loan. This possibility creates the credit risk. ”

What I need to know is:

• Which risky debt is the CFAI talking about? Is it the debt that the lenders/bondholders have lent to the equity holders?

Yes: it’s the money that lenders have lent to the company.

@girl1555

• Also what is the riskless debt here?

Treasuries, whatever.

@girl1555

• Please also explain the relation of the difference between the riskless and risky debt with the short option put’s price.

The put price for risky debt is higher than the put price for risk-free debt.

[girl1555]

@girl1555

So there is this statement given in CFAI text in Reading #38 pg 297

“The debt option analogy explains why risky debt is less valuable than riskless debt. The difference in value is equal to the short put option’s price. In essence, the debt holders lend the equity holders K dollars and simultaneously sell them an insurance policy for K dollars on the value of their assets. If the assets fall below K, the debt holders take the assets in exchange for their loan. This possibility creates the credit risk. ”

So in the case of debt option analogy why is the risky debt less valuable than riskless debt.

What does this mean that "the difference in value is equal to the short put option’s price.