Strategic analysis of contingent claims

Abstract

Traditional contingent claims analysis provides an elegant and complete model of the financing of the dynamic firm but has difficulty fitting the observations in the market. Recent work in corporate finance suggests this is because of its failure to model financial distress realistically. We survey recent efforts to address this issue by deriving valuation formulae from the analysis of non-cooperative equilibria in extensive form games. We illustrate how a simple static bankruptcy model can be incorporated in a dynamic game. We then show how to find the continuous time equivalent of this game. This we use to find closed-form bond formulae in special cases and to exploit efficient numerical techniques generally.