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FRM Part II · FRM Exam Part II · Credit Risk Management

In the Merton structural model, a firm has a single zero-coupon debt issue maturing at T. Equity holders are viewed as holding which of the following positions on the firm's assets?

Equity is a long European call option on the firm's assets with strike equal to the debt face value, because at maturity shareholders receive the greater of asset value minus debt or zero, thanks to limited liability.

  1. AA long European call option on firm assets with strike equal to the face value of debtCorrect
  2. BA long European put option on firm assets with strike equal to the face value of debt
  3. CA short European call option on firm assets with strike equal to the face value of debt
  4. DA long position in a risk-free bond and a short position in the firm's assets

Explanation

At maturity equity receives max(V - D, 0), which is the payoff of a call on firm assets struck at the debt face value. A put describes the position held by debt holders as a short put (they are long risk-free debt and short a put), not equity holders.

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