CIR 3 - Asset Value Models

Question 1

Credit Spread that debt investors require for credit risk

Answer 1

• spread s such that:

D₀ = F*e^{_-(r+<strong>s</strong>)T}

Question 2

Cash flows of a risky debt and put option to company assets

Answer 2

• regardless of the future value of A_T, the debtholder would be guaranteed a payout of F at time T, and the combined position becomes equivalent to owning a risk-less bond.

Question 3

Long put plus long position in risky debt (Asset value model)

Answer 3

Long postion in risk-less debt

Question 4

Present Value of Firm’s Equity in Merton’s Asset Value Model

Answer 4

Value of a call option on the firm’s assets:

E₀ = C₀ (A₀, σ_A, F, T, r)

Question 5

option position from firm’s point of view for issuing equity

Answer 5

Selling a call option on the firm’s assets

Question 6

Problem with asset value models

Answer 6

• Asset values are not obervable in the market
• Need to derive asset values from equity values, where market data does exist