Hi,
Can someone please explain this? So I understand that if a company defaults then Assets are used to pay off the debt which reduces equity. So where does this call option come from? And how is the debt part a put option. If someone could please explain both call option and put option part of this model.
Call If a company defaults, the equity owners would let their call option expire worthless, so the assets would be used to pay off the bonds. If the company does well, then your call option can be exercised to aquire the assets and you pay off the bond holders.
Put If a company does well and you are a bond holder, then your put option expires worthless and you just get paid your face value of bond. If the company defaults, the bond holders exercise their put option, and take the assets losing the rest of their face value.
So how is it that if the company does well then equity holders exercise the call option. Does exercising call option mean they buy back the asset i.e. get their share of assets after the debt holders are paid off?
Also how is it that as a bondholder I have the put option. What am I selling?
It’s an analogy so I don’t think it exactly translates 100% 
You’re right on the call option. For the put option, you hold the put option, so you’re just exercising it and releasing the bond to the company and getting the assets in return.
thanks
Hey 125mph, (or anyone else who is not busy at the moment) Could you please also explain the statement below? which risky debt is the CFAI talking about? Is it the debt that the lenders/bondholders have lended to the equity holders? Also what is the riskless debt? Please also explain the relation of the difference between the riskless and risky debt with the short option put’s price. "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. " (Institute 215) Institute, CFA. 2018 CFA Program Level II Volume 5 Fixed Income and Derivatives. CFA Institute, 07/2017. VitalBook file. The citation provided is a guideline. Please check each citation for accuracy before use.