Investments, tenth edition

  Levered Equity and Risky Debt 

 Investors holding stock in incorporated firms are protected by limited liability, which 

means that if the firm cannot pay its debts, the firm’s creditors may attach only the firm’s 

assets, not sue the corporation’s equityholders for further payment. In effect, any time the 

corporation borrows money, the maximum possible collateral for the loan is the total of 

the firm’s assets. If the firm declares bankruptcy, we can interpret this as an admission that 

the assets of the firm are insufficient to satisfy the claims against it. The corporation may 

discharge its obligations by transferring ownership of the firm’s assets to the creditors. 

 Just as is true for nonrecourse collateralized loans, the required payment to the credi-

tors represents the exercise price of the implicit option, while the value of the firm is the 

underlying asset. The equityholders have a put option to transfer their ownership claims on 

the firm to the creditors in return for the face value of the firm’s debt. 

 Alternatively, we may view the equityholders as retaining a call option. They have, 

in effect, already transferred their ownership claim to the firm to the creditors but have 

retained the right to reacquire that claim by paying off the loan. Hence the equityholders 

have the option to “buy back” the firm for a specified price: They have a call option. 

 The significance of this observation is that analysts can value corporate bonds using 

option-pricing techniques. The default premium required of risky debt in principle can be 

estimated by using option-valuation models. We consider some of these models in the next 

chapter.    

  One of the attractions of options is the ability they provide to create investment positions 

with payoffs that depend in a variety of ways on the values of other securities. We have 

seen evidence of this capability in the various options strategies examined in Section 20.4. 

 Options also can be used to 

custom-design new securities 

or portfolios with desired pat-

terns of exposure to the price 

of an underlying security. In 

this sense, options (and futures 

contracts, to be discussed in 

Chapters 22 and 23) provide 

the ability to engage in  finan-

cial engineering, 

 the creation 

of portfolios with specified 

payoff patterns. 

 A simple example of a prod-

uct engineered with options 

is the index-linked certifi-

cate of deposit. Index-linked 

CDs enable retail investors to 

take small positions in index 

options. Unlike conventional 

CDs, which pay a fixed rate of 

interest, these CDs pay deposi-

tors a specified fraction of the 

    20.6 

Financial Engineering 

Rate of Return on Index-Linked CD

Slope 

= .7

r

M

 

= Market Rate

of Return