Bankers and investors putting on debt versus equity trades are drawing on the idea first expounded by Nobel economics laureate Robert Merton that equity can be thought of as a call option on the assets of a firm. If the share price dips below a certain level – implying a lower value on the firm’s assets and cashflows relative to its liabilities – default will follow. Bondholders, meanwhile, have sold an equity put option to the issuer and the spread on a corporate bond is the premium for taking that position.
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