Chapter 19

Engineering of Equity Instruments and Structural Models of Default

In this chapter, we discuss how financial engineering and option pricing principles can be used to value equity and equity-linked products. We first review the structural models of default and show how they can be used to link bond, CDS, and equity markets. We discuss the different uses of the basic Merton (1974) model to calculate the value of equity, to back out implied credit spreads, or to back out an implied equity volatility. We show how the Merton model is applied in practice to inform capital structure arbitrage strategies. Next, we introduce another class of bonds with embedded options in the form of convertible bonds. Convertible bonds can be decomposed into ...

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