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FRM Part II · FRM Exam Part II · Credit Value at Risk

In the Merton structural model, a firm's equity is viewed as a financial option. Which description correctly characterizes the equity position, given that the firm has issued a single zero-coupon bond maturing at time T?

Equity is a European call option on the firm's assets with strike equal to the face value of the zero-coupon debt, because at maturity shareholders receive the residual asset value above the debt claim, or nothing if assets fall below it.

  1. AA European put option on the firm's assets with strike equal to the face value of debt
  2. BA European call option on the firm's assets with strike equal to the face value of debtCorrect
  3. CAn American call option on the firm's debt with strike equal to the asset value
  4. DA European call option on the firm's assets with strike equal to the market value of debt

Explanation

At maturity equity holders receive max(V - D, 0), the payoff of a call on firm assets struck at the face value of debt. A put describes the position of debt holders' short exposure, not equity. The strike is face value, not market value.

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