Accounting for Financial Instruments: An Option Pricing- Based Approach to Measuring Corporate Debt Components
Posted: 28 Apr 1998
Date Written: Not Provided
Many of the Financial Accounting Standards Board's current agenda items relate to measuring financial instruments' fair values, many of which have option-like characteristics. This study presents evidence on the potential practical applicability of using option pricing theory to account for one financial instrument and its components, corporate debt. We implement two alternative versions of the binomial option pricing approach to estimate values for corporate debt and its components, including straight debt and conversion, call, put, and sinking fund features. Comparisons of total debt model estimates to available market values indicate they are quite close when equity volatility is implied by the model; model estimates generally exceed market values when it is forced to equal the historical estimate. Components' value estimates empirically are sensitive to estimation order. Most notably, call and conversion features affect each other's estimates, and both affect put feature's estimates. Sensitivity analyses of model estimates to dividend payout and equity volatility assumptions indicate that they vary little with all but extreme changes in these parameters.
JEL Classification: G12, G13, M41
Suggested Citation: Suggested Citation