I do not quite follow the reasoning in the section about the Structural approach. It starts off describing debt with credit risk as: *riskless debt; less *put option. (I understand this reasoning, which is also given in an earlier chapter) BUT: Then the in formula given, V0-E0, E0 is the value of a call option on the assets and V0 is the value of the assets. This comes from the other (put-call parity) way to view debt with credit risk as: *value of assets; less *call option. Please let me know where I am missing the point of the first part of this section where it is explained that evaluating the put option is equivalent to evaluating the credit risk.
Structural Approach Hi, The value of the call option is known=E0=market cap of shares. They only use this to get a simultaneous equation to solve for V0. Once V0 is found (from the call option equation) you can then solve for the value of the debt. D0=V0-E0 and then need to find riskless equivalent and solve for put+D0 = riskless. Does this sound right?
OK. So the aim of the structural approach is to calculate: * value of the credit risk = value of put option = value of riskfree debt - value of risky debt = value of riskfree debt - [V0 - E0] OR * the risk neutral probability of default PHI(-d2) For both of these we need to find V0 which we get from the simultaneous equations.
