PRM 3 – Question 66 – contingent claims framework

[Jeffrey Chudy]

PRM 3 – Question 66 – contingent claims framework

[Anonymous]

Hi,
FYI
The explanation to this question does not agree to the answer choices. For example, the explanation says statement IV at the end, but (a) is the correct in the beginning.

Thanks

Question 66 : Assuming all other factors remain the same, an increase in the volatility of the returns on the assets of a firm causes which of the following outcomes?
(a) A decrease in the value of the non-callable debt issued by the firm
(b) A decrease in the value of the implicit put in in the debt of the firm
(c) An increase in the value of the callable debt of the firm
(d) An increase in the value of the equity of the firm

Your Answer is Incorrect

The correct answer is choice ‘a’

Some parts of this question draw upon contingent claims framework to the value of a firm. According to this framework, the relationship between the debt and equity holders of a firm can be viewed as follows: The equity holders have a call option on the assets of the firm with a strike price equal to the value of the debt, and the debt holders have sold them this call. This is so because should the value of the assets of the firm fall below the value of the debt, the equity holders can walk away by handing over the assets to the debt holders in full extinguishment of their claims. If the value of the firm’s assets is greater than the value of debt, the equity holders will exercise their call option. At the same time, it is also possible to view the debtholders as holding an asset and having sold a put on the assets of the firm with a strike price equal to the value of the debt. If the value of the assets of the firm were to fall below the value of the debt, they will end up buying the assets at a price equal to the value of the debt.

An increase in the volatility of returns on the assets of a firm increases the volatility of the asset value. This means the likelihood that the asset value will go below the value of the debt of the firm will increase. Callable debt can be considered to be a summation of two separate securities: a regular debt, for which the firm pays interest and receives a principal loan; and a call option that the debt holders have sold to the firm allowing the firm to buy back the debt. In return, the firm pays an implied ‘premium’ to the debt holders who have agreed to buy the callable debt. Therefore the total payments by the company to callable debt holders is equal to the interest payments plus the premium payment for the option. An increase in asset volatility will increase the value of this option as it is likely that the assets will increase in value, and strengthen the company’s credit, and lower its spread at which time it would like to repay the debt and refinance/roll over at the new lower rate. Therefore an increase in volatility will increase the ‘premium’ demanded by the callable debt holders, thereby increasing the total yield and lowering the value of the callable debt. Therefore statement I is incorrect.

An increase in asset volatility will decrease the value of the firm as it is now riskier than before (higher standard deviation, same expected returns). Therefore statement II is false too.

The value of the implicit put in the debt of the firm will increase and not decrease as the volatility of the underlying assets increases. Therefore statement III is incorrect too.

Statement IV is correct because higher asset volatility will increase the riskiness of the company’s debt, making the required yield higher and decreasing its value.

[Anonymous]

This is a screw up on my part. The website randomizes the choices a through d, and correspondingly changes ‘choice a’ etc to the new random value. But in the explanation I have hard-coded ‘statement I’ etc, which is causing this problem.

But very well spotted, thank you for noticing and taking the time to point it out. Now fixed.

Best regards,
Mukul

[Author]

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