Financial Daily from THE HINDU group of publications
Sunday, Dec 08, 2002
Financial Daily from THE HINDU group of publications Sunday, Dec 08, 2002 |
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Investment World
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Derivatives Markets Markets - Derivatives Markets Columns - Simple Economics Of call options for shareholders B. Venkatesh
ALL of us are aware of equity options. These are derivative contracts with equity as the underlying instrument. An option on Satyam, for instance, is a derivative contract with Satyam stock as the underlying instrument. But did you know that a company's stock itself is an option? Take a company that has Rs 150 crore in shareholder funds, and Rs 100 crore in borrowings. Suppose the company incurs huge losses and its shareholder funds reduce to Rs 75 crore? If the company decides that it is unlikely to perform better in the future, it will default on its debt payments. The result? The debtors will seize the assets of company, sell them, and try to recover their loan. Notice that the company exercised its right to default. If the company were performing well, it would repay the loans. This right of the company to default or not can be structured as a call option! How? In a call option, the buyer gets the right, but not the obligation, to buy the underlying instrument at a pre-determined price on a pre-determined date. Now transport this logic to the above example. The shareholders hold a call option when they borrow money. This is because they can exercise their right to buy back the company from the debt-holders. This they will do when the shareholder funds are more than the total debt, or when they think that the company is performing well. They will choose not to exercise their right if total debt is higher than shareholder funds. The strike price for the option contract is the price of the debt, or the loan amount that the shareholders will repay. To extend this concept, an equity option will then become a compound option, because it is an option on equity, which itself is an option!
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