FI - very lost

CFA Level II Fixed Income
#1

ok, so the below is an early paragraph in the structural models section… Have no idea what they are talking about. Mixing in options with a firm’s debt…

Can someone please take the time to explain this??

THANKS A TON.

Consider a company with assets that a financed by equity and a single issue of zero-coupon bond. The vlaue of the assets at any point in time is the sum of the value of equity and the value of debt. Due to the limited liablity nature of coprorate equity, the shareholders effectively have a call option on the company’s assets with a strike price equal to the face value of debt. If at maturity of the debt, the value of the company’s assets is higher than the face value of debt, the shareholders will exercise the call option to acquire the assets ( and hthen pay off the debt and keep residual). On the other hand if the value of the company’s assets is less than face value of debt, the shareholders will let the option expire worthless (default on the debt), leaving the comapny’s assets to the debt holders.

Second paragraph: We can also say that owning risky debt with a face value of K, is requivalent to owning a risk-free bond with the same face value (K0 and writing a european put option on the assets of the company with a strike price of K> If the value of the assets is greater than the face value of debt, the put option will be out of tmoney and not exercised, and the debt holder will simply receive the face value.

#2

There was a previous thread around this that might be helpful:

http://www.analystforum.com/comment/91495322#comment-91495322

but otherwise, this is just trying to deconstruct a balance sheet and ownership structure to its basic level.

It might be easier if you breakdown specific questions so they can be addressed

#3

ok wow, this little seciton on Credit analysis models is still h**l. I’m assuming you dont need to know any of the formulas… just how to replicate cash flows…

I also heard that this wasn’t in the curiculum on previous exams? Thus meaning there is a very high % this shows up on the exam?

#4

I suppose you are right .The formulae are not important . According to me all we need to know is the difference between both the methods and the idea behind them.