Lesson 5 of 5 · 11 min

Put–call parity and the value of the firm

With zero-coupon debt of face value D, shareholders hold a call on the firm's assets and debtholders hold risk-free debt minus a put, so V0=c0+PV(D)−p0V_0 = c_0 + PV(D) - p_0.

In short

  • Firm value equals equity plus debt: V0=E0+debt valueV_0 = E_0 + \text{debt value}. At maturity T the debt's face value D is due.
  • If VT>DV_T > D (solvent), debtholders get D and shareholders get VT−DV_T - D. If VT<DV_T < D (insolvent), debtholders get VTV_T and shareholders get 0.
  • Shareholder payoff max⁡(0,VT−D)\max(0, V_T - D) is a call on firm value with exercise price D: unlimited upside, limited downside.
  • Debtholder payoff min⁡(VT,D)=D−max⁡(0,D−VT)\min(V_T, D) = D - \max(0, D - V_T) is risk-free debt plus a sold put on firm value: upside capped at D.
  • Parity gives V0=c0+PV(D)−p0V_0 = c_0 + PV(D) - p_0. The put's value reflects the credit spread; it rises as insolvency becomes more likely.

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Put–call parity and the value of the firm · Option Replication Using Put–Call Parity