Debt of a company can be modeled as a long position in a risk-free bond and a short position in a put option. What in the heck does this mean?
The only way I can see this is from the standpoint of the investor. You are long a risk free bond because you get periodic payments and a final principal payment. However, you are also ‘short’ a put option on the company because you get a ‘premium’ for the additional credit risk, but if the company flops (the value of the company falls), you stand to lose since you wrote the option. That’s my take. Thoughts?
If I issue 100 dollars of bonds, I can invest the money anywhere. I can expect to at least earn the RFR. If I fail to repay coupons and payments, I can default on the debt and have the debtors liquidate my assets. So I have RFR plus put option i.e. option to settle whenever. Totally a shot in the dark here.
^hmmmm…interesting. When I saw this question…I used the Put-Call parity to help me “guess” the answer. Since bank is long on the asset. S=X/(1+rfr)+C-P. That was how I got the idea of long rfr and short put. I am sure there is flaw in my thinking, somebody please correct me.
this has been discussed http://www.analystforum.com/phorums/read.php?13,710054,710054#msg-710054
Thanks volkovv - makes perfect sense now. The wording was messed up.
Hmmm… Corp Bond = Long RFR Bond + short Put ??? Sounds close to right, but not quite. I’d think that it’s a put on the total asset value of the company with a strike price = debt liabilities. Here’s the test. If the company’s equity goes to exactly 0 but liabilities are covered by assets still (so no bankruptcy, but all equity is gone), in version 1 you have to fork out the put’s strike price. you still get the RFR bond, but the total is less, and could be negative. However, the corporate bond would still be paid in full, so the equation doesn’t balance.
The solution mentions p.44-46, CFAI vol 5, which says (last line on p.44): " … a bond with credit risk can be viewed as a default-free bond plus an implicit short put option written by the bondholders for the stockholders" - sticky