Topic 5 - Options and Corporate Finance: Applications

Question 1

What is delta a measure of? what is the delta of a call in the BS model, of a put?

Answer 1

sensitivity of option price to change in underlying stock price (d1 give you delta of a call, d1 - 1 give delta of a put)

Question 2

what is delta hedging?

Answer 2

Construction of a riskless hedge portfolio

Question 3

When considering equity as a call or a put, in which situations would you want to hold equity as a call and when would you want equity as a put?

Answer 3

a Call when A > D - pay bondholders strike price (value of debt) and take control of assets
a Put when D > A - “put” firms assets to bondholders to pay off debt and declare bankruptcy

Question 4

Which two risks are the agency cost of debt?

Answer 4

That managers will:

• Substitute riskier investments (ie, should have paid a higher rate of interest)
• Pay higher dividends, leaving fewer assets as collateral

Question 5

Why are stocks worth more with high risk projects?

Answer 5

Because the call option that the shareholders of the levered firm hold is worth more when the volatility of the firm is increased

Question 6

how is the Value of default-free bond calculated?

Answer 6

Value of default-free bond

= Value of risky bond + Value of default put

Question 7

When do shareholders benefit from guarantee of a default put?

Answer 7

• if new debt is being guaranteed, sell debt at lower i rates
• if existing debt is being guaranteed then the bondholders benefit

Question 8

slide 36

Answer 8

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