Contingent Claims Valuation when Capital Structure Includes Options Liability

The paper shows how the traditional credit model based on contingent claims analysis can be adjusted when the capital structure includes a short position in a call or put option. The stochastic features of the asset underlying the option introduce additional risk elements into the analysis of corporate claims valuation. This leads to revising the usual pricing of credit risk for firms with significant Off-Balance-Sheet (OBS) liabilities. Typical examples that apply to this situation include financial or commodity firms. Derivatives are often ignored because of their small transaction size. The importance of the leverage they introduce is also unclear, perhaps due to their complexity. However, the combined effect of several derivatives on other claims of equal or lower seniority cannot be ignored, especially in light of the growing use of derivatives by financial and non-financial firms in recent years. The paper uses the vulnerable options methodology to bring out the importance of options influence on corporate claims. It is found that the values of debt, option and equity are less than the value of their standard counterparts. In particular, numerical illustrations show that senior and subordinated debt values (spreads) are smaller (higher) than in the standard case without the option. Furthermore, the volatility of the asset underlying the call or put option and the volatility of the assets of the firm appear to be negatively related to debt value