Derivatives: Markets, Valuation, and Risk Management

CHAPTER 12

Corporate Securities

Firms issue different types of securities to finance the assets of the firm—common stock preferred stock, discount bonds, coupon bonds, convertible bonds, warrants, convertible bonds, and so on. Some are issued to the public and are actively traded in the secondary markets. Others are placed publicly, but trade infrequently. Yet others are privately placed, and trade seldom if at all. The purpose of this chapter is to show how all of the firm's securities outstanding can be valued using only information regarding the firm's common stock price and volatility rate. This is possible because all of the firm's securities have the same source of uncertainty—the overall market value of the firm's assets. Consequently, all of the firm's securities have price movements that are perfectly correlated with one another over short periods of time. With such being the case, all corporate securities can be valued using information about the price and volatility rate of any one of the firm's outstanding securities. We choose to use the common stock of the firm because, of all the firm's securities, it has the deepest and most active secondary market. In this sense, all corporate securities may be considered common stock derivatives.

To develop the corporate security valuation framework, we rely on the BSM option valuation results from Chapter 7. The underlying source of uncertainty is the firm's overall market value, which we assume is log-normally distributed in ...