pennyless

The point they're making is that the liability of the shareholders is limited to the assets of the company.
The current value of the bond purchased by the bondholders ( who wrote the put ) is the difference between present value of a zero-credit-risk bond paying no coupons ( i.e. an instrument that has only market risk ) and the put option value represented in collateral form by assets of the company which are used to secure the bond. If the assets of the company are high , the put option expires worthless and bondholders get the entire face value of their loans back at maturity.

If the company gets into trouble ( credit related ) then the value of the assets will decline and the bond holders will get less at maturity i.e. they will get the face value LESS some amount.

The amount could be zero meaning their loan's entire face value could be wiped out , depending on the size of the assets left after bankruptcy relative to the loans undertaken .

In any case shareholders do not have to put up anything more. They already pledged the assets of the company in return for the loan . They bought a put option at a cost reflecting the size of the assets and the size of the loan



Edited 1 time(s). Last edit at Tuesday, March 29, 2011 at 10:40AM by janakisri.