CFA Level I · CFA Level I Exam · Credit Risk
In a structural model of credit risk, the equity of a firm is most likely viewed as:
Equity is best viewed as a call option on the firm's assets with a strike equal to the face value of debt. At maturity shareholders receive the excess of asset value over debt, or zero if assets fall short, which is a call payoff.
- Aa call option on the firm's assets with a strike price equal to the face value of debtCorrect
- Ba put option on the firm's assets with a strike price equal to the market value of debt
- Ca forward contract on the firm's liabilities with a strike equal to retained earnings
Explanation
Structural models (Merton) treat shareholders as holding a call on the firm's assets, struck at the debt face value. Shareholders keep the residual if asset value exceeds debt at maturity and get nothing otherwise. The put description fits the lenders' implicit short position, not equity, and the strike is face value, not market value.
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