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Theory

1.Problem 3 Suppose you are the manager and sole owner of a leveragecompany. All debt will

maturein one year .If at the time the value of the company`s assets aregreater than the face value

ofthe debt, you will pay off the debt. If the value of the company`sassets is less than the face

valueof the debts, you will declare bankruptcy and the debt owners willown the company.

(a)Expressyour position as an option on the value of the company.

Thinkof enterprise value as the theoretical takeover price. In the eventof a buyout, an acquirer

wouldhave to take on the company`s debt, but would pocket its cash. EVdiffers significantly

fromsimple market capitalization in several ways, and many consider it tobe a more accurate

representationof a firm`s value. The value of a firm`s debt, for example, wouldneed to be paid

bythe buyer when taking over a company, thus EV provides a much moreaccurate takeover

valuationbecause it includes debt in its value calculation.

(b)Whatwould you do to increase value of your position?

Make certain that the company`s assets continues to be proportionallylarger than the company`s

equity

(d)Howwould you define probability of default of the firm? Could youdetermine a `risk neutral`

probabilityof default?

Involvesdistinguishing point-in-time(PIT)and through-the-cycle-(TTC)can beused both in the

contextof probability of default as a rating system. In the context ofprobability default.

Itmay be obtained from a historical data base of actual default usingmodern technologies like

logicregression. It may also be estimated from the observable prices ofdefault swaps, bonds

andoptions on common stock

Problem4(first American Bank: credit-default swaps)

(a)Whatis a default wsap?

Itis a agreement that the seller of the credit-default swap(CDS)willcompensate the buyer in the

eventof a loan default or other credit event. The buyer of the CDS makesa series of payments

tothe seller and in exchange receives a pay off if the loan defaults.In the event of default the

buyerof the CDS receives compensation and the seller of the CDS takespossession of the

defaultedloan.