CFA Level I · CFA Level I Exam · Credit Risk
In a structural model, holding other inputs constant, an increase in the volatility of the firm's asset value is most likely to:
Higher asset volatility raises equity value and lowers risky debt value. Equity is a call option that gains from volatility, while the shareholders' implicit put on the assets becomes more valuable, reducing what creditors' debt is worth.
- Adecrease the value of equity and increase the value of risky debt
- Bincrease the value of equity and decrease the value of risky debtCorrect
- Cincrease both the value of equity and the value of risky debt
Explanation
Equity is a call option, and option value rises with volatility. Risky debt equals the risk-free debt minus a put held by shareholders, which also gains value with volatility, so debt value falls. Total firm value is unchanged, so both cannot rise.
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