CFA Practice Question

There are 206 practice questions for this study session.

CFA Practice Question

Equity can be viewed as a call option on a firm's assets. True or False?
Correct Answer: True

User Contributed Comments 17

User Comment
anita call option is an option to buy a security at predetermined price ..
yanpz Why it's true?
george2006 X=0, T=infinity
tanyak how can there predetermined price on equity?
omer123 Option is an instrument which derives it value from the underlying asset, which in true essence is what equity is, since it derives it value from the financial health of a firms assets.
bobert As anita said, "call option is an option to buy a security at predetermined price .."

This makes the statement true because if you buy a call option, you have essentily reserved the right to purchase a stock (for example) at that determined price. Branching off of what omer123 and george2006 said, if you own the stock today, you have have a predetermined price (the price you bought at) worth of ownership in the underlying company. The price of the stock may rise, but you still have the same ownership at a lower price. (assuming the stock has not since been diluted. But do not think that far into it)
jainrajeshv Well explained by bobert
tgeorg but no specified expiration date
NavdeepS george , T= infinity or in case of a US bank hobbled with subprime assets , t= time until insolvency or a government bailout ;)
asthildur The pioneers of option pricing were Fischer Black, Myron Scholes, and Robert Merton. In the early 1970s, they showed that options can be used to characterize the capital structure of a company. Today this model is widely used by financial institutions to assess a company's credit risk.
To illustrate the model, consider a company that has assets that are financed with zero-coupon bonds and equity. Suppose that the bonds mature in 5 years at which time a principal payment of K is required. The company pays no dividends. If the assets are worth more than K in 5 years, the equity holders choose to repay the bondholders. If the assets are worth less than. K, the equity holders choose to declare bankruptcy and the bondholders end up owning the company.
The value of the equity in 5 years is therefore max(AT - K, 0), where AT is the _value of the company's assets at that time. This shows that the equity holders have a 5-year European call option on the assets of the company with a strike price of K.
What about the bondholders? They get min(AT , K) in 5 years. This is the same as K - max(K - AT, 0). The bondholders have given the equity holders the right to sell the'company's assets to them for K in 5 years. The bonds are therefore worth the present value of K minus the value of a 5-year European put option on the assets with a strike price of K.
To summarize, if c and p are the value of the call and put options, respectively, then: Value of equity = c, Value of debt = PV(K) - P
Denote the value of the assets of the company today by Ao. The value of the assets must equal the total value of the instruments used to finance the assets. This means that it must equal the sum of the value of the equity and the value of the debt, so that Ao= c+[PV(K) - p]
Rearranging this equation, we ~ave c + PV(K) = p + Ao
This is the put-call parity
asthildur nb.. information where obtained from Hull: Option, Futures and Other derivatives.
viannie Equity = call option on a company's assets

Asset = Liability + Equity
anastasiya Equity is no contingent claim. it is a residual claim on a company's assets - see the comment of viannie. There is nothing contingent in equity.
vinooka Thanks Asthildur! Very well explained.
johntan1979 Companies can repurchase outstanding shares... that's it and that's all there is to understand.
sauresh Well explained johntan 1979!
Shaan23 Johntan is great.
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