Financial Contracting in the Presence of Multiple Indenture Provisions: An Option Pricing Framework

Abstract:     
Modern economic theory views a corporation as a complex collection of contracts between management, debtholders, and shareholders. To control risk shifting, in practice indenture provisions are frequently embedded in these contracts but are assumed away in many theoretical economic models. This paper offers a general theory for the pricing of virtually any financial claim on the firm that is constrained by protective coventants. Central to our analysis is the belief that the payoff from any financial contract can be expressed as a portfolio of options. We assume the existence of the financial contract is contingent on the legal requirements being satisfied and model the continuous surveillance/enforcement of indenture provisions as restrictions on multidimensional first passage time.

JEL Classification: G13

working papers series