Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 14. Options and Corporate

Finance

© The McGraw−Hill^509

Companies, 2002

Convertible bonds are almost always callable. This means that a convertible bond is
really a package of three securities: a straight bond, a call option held by the bondholder
(the conversion feature), and a call option held by the corporation (the call provision).

Put Bonds Put bonds are a relatively new innovation. The owner of a put bond has
the right to force the issuer to repurchase the bond at a fixed price for a fixed period of
time. Such a bond is a combination of a straight bond and a put option; hence the name.
For example, in Chapter 7, we briefly discussed a LYON, a liquid yield option note.
This is a callable, puttable, convertible, pure discount bond. It is thus a package of a
pure discount bond, two call options, and a put option.

Insurance and Loan Guarantees Insurance of one kind or another is a financial fea-
ture of everyday life. Most of the time, having insurance is like having a put option. For
example, suppose you have $1 million in fire insurance on an office building. One night,
your building burns down, which reduces its value to nothing. In this case, you will ef-
fectively exercise your put option and force the insurer to pay you $1 million for some-
thing worth very little.
Loan guarantees are a form of insurance. If you loan money to someone and they de-
fault, then, with a guaranteed loan, you can collect from someone else, often the gov-
ernment. For example, when you loan money to a commercial bank (by making a
deposit), your loan is guaranteed (up to $100,000) by the government.
In two particularly well-known cases of loan guarantees, Lockheed (now Lockheed
Martin) Corporation (in 1971) and Chrysler (now DaimlerChrysler) Corporation (in

CHAPTER 14 Options and Corporate Finance 481

FIGURE 14.4

Value of a Convertible

Bond versus the Value

of the Stock for a Given

Interest Rate

Convertible

bond value

Stock

Straight bond value price

greater than conversion

value

Convertible bond

values

Conversion

value

Straight bond value

Straight bond value

less than conversion

value

Floor value

Floor value

Option

value

As shown, the value of a convertible bond is the sum of its floor

value and its option value (highlighted region).

= Conversion

ratio