Contemporary Finance

9Credit and Counterparty Risk

9.1 Default, Bankruptcy, and Resolution

9.1.1 Equity, Debt, and Leverage

Credit analysis begins with a firm’s or household’s balance sheet. A firm acquires assets with a view to making a positive net return, funded by issuing claims, in two contractually distinct ways. Equity in its simplest form are the funds directly invested by owners of the firm, including paid-in capital and retained earnings. More broadly, equity can be shareholder or partner equity, the down payment on a house, or the part of a position funded by the trader rather than a dealer.

Equity is a residual claim on earnings; any revenues not owed to other parties flow to the equity investors. Debt is a contract providing fixed obligations in exchange for the funds. Debt holders have claims only to contractually stipulated returns. If the debt exceeds the asset value, limited liability law precludes recourse to other property of owners. Therefore, equity has characteristics in common with options.

These funding contracts are ultimately traceable to the distinct investment roles of those taking on a limited part or the brunt of the uncertainty pervading any enterprise. Investors looking to limit their risk will prefer a contractually guaranteed income, while the more venturesome will prefer the potential high return of a residual income. Equity stakes and ownership of firms are also linked to control over firm management. As firm organization and its legal framework have evolved, ...