Could someone pls explain the following sentences? They’re from the curriculum.
Consider these payoff profiles in terms of options:
Shareholders hold a long position in the underlying firm’s assets (VT) and have purchased a put option on firm value (VT) with an exercise price of D; that is, max(0, D – VT).
Debtholders hold a long position in a risk-free bond (D) and have sold a put option to shareholders on firm value (VT) with an exercise price of D.
Imagine a firm with no debt
The value of the equity = value of the assets
100 = 100
Now the company takes on debt of 50
Now the equity shareholders have right to asets above 50 and debt holders to everything below 50.
The equity position looks like a call option strike 50.
This the same as being long the all the assets but bought a put at 50.
Below 50 the losses belong to the debt holder
Above to the gains to the shareholder
Debt holder is short this put.
Below 50 they are taking the losses but they have no upside above 50.
You could say the premium they earn on the put is the risk premium on debt.