Abstract
Contingent claims theory has shown that because of limited liability in bankruptcy, there are embedded options in the plain vanilla stock, bonds, and other securities issued by a firm that affect their values. When a firm issues claims that are themselves options on some underlying asset, the various sources of optionality interact with one another. For example, if the written option gets too deep in the money, the firm will have to default on its obligation. This places an effective cap on the potential payoff to the option holder. The impact on the value of subordinated debt becomes particularly complex. In this article, Episcopos clarifies how the values of corporate securities are affected when a firm’s capital structure includes a significant short option position.
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