Equity and debt in a firm are option-like. Which of the following options are they?
A) Equity is akin to a short call and debt is akin to a package containing a long put.
B) Equity is akin to a long call and debt is akin to a package containing a short put.
C) Equity is akin to a short put and debt is akin to a package containing a long call.
D) Equity is akin to a long put and debt is akin to a package containing a short call.

Question

Quizplus · Accepted Answer

Equity behaves like a long call option because it gives the holder the right, but not the obligation, to purchase the underlying asset (the value of the firm) at a certain price (the share price). Debt behaves like a short put option because it reflects a fixed obligation to purchase the underlying asset (pay back the loan) at a certain price (the interest rate). A package containing a short put option would be a combination of short-term debt and equity, while a package containing a long put option would be a combination of long-term debt and equity. Therefore, option B is the best choice because it accurately reflects the nature of equity and debt as option-like instruments.

Equity and Debt in a Firm Are Option-Like