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How is equity an option?
Equity options are a form of derivative used exclusively to trade shares as the underlying asset. They offer the trader the right, but not the obligation, to purchase (or sell) a set amount of shares at a certain level (referred to as the ‘strike price’) before it expires. To buy an option, traders will pay a premium.
How your firm’s equity can be viewed as an option?
Equity can thus be viewed as a call option the firm, where exercising the option requires that the firm be liquidated and the face value of the debt (which corresponds to the exercise price) paid off.
Are options equity or debt?
In finance, an equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively traded.
What is a call option in private equity?
As with a put option, a call option is generally exercisable by the buyer during an agreed timeframe. The call option therefore gives the buyer a level of security given that it entitles them to purchase the seller’s shares for a pre-agreed price during the agreed limited timeframe.
What does it mean to have equity call option?
The owners and share-holders of a company, the equity holders can think of their equity in terms of a call option on the company. A call option gives the investor the right to buy the underlying security at an agreed upon price any time between today and the option expiration.
By using the Black-Scholes formula, an equity call option’s premium can be calculated. From there, the total amount of risky debt (equal to the total worth of the firm minus the equity value) and risk-free debt (equal to the risky-debt value plus the put value it would take to protect the risky debt) can be derived.
Who are the equity holders of a company?
Equity holders are the owners and shareholders of a company. Equity holders own the cash flows in excess of the company’s obligations. They also hold all the value of the company above and beyond what is owed to the debt holders. Let’s say XYZ Corp is a company whose stock trades publicly with both debt holders and equity holders.
What’s the value of a risky debt option?
The risky debt value is equal to the total value of the firm minus the equity value. In this case, it’s $100 million minus the $36 million or $64 million. For debt holders which want to make this debt risk-free, they’d need to provide themselves some downside protection.