The principle underlying the contingent claims approach to measuring credit risk equates the cost of eliminating credit risk for a firm to be equal to:
A.
the cost of a call on the firm's assets with a strike equal to the value of the debt
B.
the value of a put on the firm's assets with a strike equal to the value of the debt
C.
the probability of the firm's assets falling below the critical value for default
D.
the market valuation of the firm's equity less the value of its liabilities
Under the contingent claims approach, a firm will default on its debt when the value of its assets fall to less than the face value of the debt. Debt holders can protect themselves against such an event by buying a put on the assets of the firm, where the strike price is equal to the value of the debt. In other words, Risky Debt + Put on the firm's assets = Risk free debt. This is because if the value of the assets is greater than the value of the debt, they will be paid in full. If the value of the assets is lower than the value of the debt, they will exercise the put and be paid in full.
Therefore the value of the put on the firm's assets with a strike equal to the value of the debt represents the cost of eliminating credit risk. Choice 'b' is the correct answer.
Note that it is improbable that a put on the firm's assets is available in real life to debt holders. However, the same effect can be synthetically achieved by using the shares of the firm as a proxy for its assets, and shorting an appropriate number of shares. Such a synthetic put will require frequent readjustments.
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