Derivatives

CHAPTER 30Other Options

Aims

• To show how a corporate's debt and equity can be valued using options theory.
• To examine different types of equity warrants, which are long-term options on a company's stock.
• To examine quantos which are long-term equity options written on foreign stocks but with the payout in the home currency.
• To show how an equity collar enables a portfolio manager to set an upper and lower limit on the performance of her existing equity portfolio. If this is achieved at zero ‘up-front’ cost then it is known as a zero cost collar or a risk reversal.

In this chapter we show how the debt and equity of a firm can be valued using options theory. Then we examine equity warrants, which are stock options ‘attached to’ bonds. Finally, we discuss how an equity collar places a floor price and a ceiling price on a stock (or stock portfolio).

30.1 CORPORATE EQUITY AND DEBT

Merton (1974) and Black–Scholes (1973) noted that the debt and equity of a firm can be valued using options theory. Suppose a corporation has two sources of finance, debt and equity . If the value of the firm's assets at time t, exceeds the face value of debt (bonds) outstanding then the equity holders ...