“Owning equity is economically equivalent to owning a European call option on the assets of the company. Owning debt is economically equivalent to owning a risk free bond and simultaneously selling a put option on the assets of the company.” Can anyone explain this. Thanks in advance.
Synthetic assets can replicate the economic outcomes of financial or real assets.
In the case of Equity. Owning equity (going long a stock) is equivalent to going long a Call Option on that stock or its assets. For example, if you buy a stock for $50 and it goes to $51, you gained $1 (or 2%) on your investment. If you have a call option with a strike price of $50 and the stock goes to $51, you gained $1. Note that going long an option means paying for a premium. However, in this “theoretical” case, having a call option on the assets of the company is like owning equity because if assets get more value, equity will do aswell.
In the case of Debt. Owning debt (lending money to a company) is equivalent to owning a risk free bond and selling a put option on the assets of the company. The bond face value is the money lent. Additionally, as lender, you are automatically selling a put option to shareholders because shareholders will NEVER pay above the equity value they hold.
A brief explanation with numbers: Imagine a company with $100 in assets, $70 in debt and of course $30 in equity. By the time the asset value of the company reaches $70, shareholders are wiped out and the lender can liquidate those $70 in assets and all good for the lender. By the time the asset value goes to $60 for example, shareholders are wiped out aswell, but they don’t keep owing any money to debtholders, they are LONG a PUT option on the assets and the strike price is $70 (a put sold by the lender), below that, shareholders are protected and just lose their equity.
About the risk free bond, why lenders own a risk free bond? It is because in case of bankruptcy, lenders have the priority over the remaining assets of the company. As seen in example above, lenders are the ones that seize the available assets, but if they find less assets than the amount they lent, they will lose that portion because they are SHORT a PUT.
Hope this helps!
Thanks a lot for this, it throws light to a lot of portions. However, I have two questions as below from the explanation you given.
- In the case of debt, as per your explanation, if I understood it in the right way, it should be read as “Owning debt is economically equivalent to owning a risk free bond and simultaneously buying a put option on the assets of the company” instead of “Owning debt is economically equivalent to owning a risk free bond and simultaneously selling a put option on the assets of the company”.
- The last line of the fifth para, I think shareholders are unprotected rather than protected. Is it a typo or I am stilling missing a point here?
As explained, the lender loses money if in case of distress, the remaining asset value is less than the outstanding debt. This behavior is consistent with being SHORT a PUT (selling a Put). If you write / sell a put, you lose money when the current price goes below the strike price. In this case, asset value going below outstanding debt. On the other side of the transaction, the buyer of the put (shareholders) are protected if asset value go below outstanding debt because shareholders lose their equity but don’t owe any other amount to the lender despite the remaining assets don’t cover the value of the outstanding debt.
Have you ever heard about people dumping their mortgaged houses when the house value goes below the remaining mortgage debt? This is exactly the same case.
We are talking about the DEBT itself, not about their shares. Shareholders lose their shares in case of bankruptcy, they lose all equity, it goes to 0. But they pay nothing additional to lenders if the remaining company assets worth less than the outstanding debt, lenders lose there.