2005,25B(2):243-247

OPTIONS-GAME ANALYSIS FOR FIRM WITH

INSURED DEBT
Mei Zhengyang (

 )

Li Chulin (

)

Department of Mathematics, Huazhong University of Science and Technology, Wuhan 430074, China

Abstract The strategic model for insured bond of firm is a new model which is developed
based on options pricing model and game theory. When firms bond was insured against
bankruptcy, some interesting results about endogenous bankruptcy and optimal capital
structure are obtained.
Key words

Insured bond, endogenous bankruptcy, optimal capital structure

2000 MR Subject Classification

34A05, 60G40

Introduction

Consider an economic system under efficient markets hypothesis, the uncertainty in the
economy is characterized by a probability space (, F , P)which represents the risk neutral
probability measure in the economy, and a standard Brownian motion {Wt : t 0}. We denote
by { F t : t 0 } the filtration generated by Wt . In this paper, we consider an asset, St that the
stocks value of underlying assets, which took away the interest and insurance premium, and a
perpetual bond D0 that the face value of firm issued insured debt. Asset value of the firm is
observable completely for the insurer, the risk-free interest rate of market is r (0, 1). Any
conflicts of interest between management and equity holder are ignored.
Assumption 1[2] The stock price St satisfies the standard geometric Brownian motion:
dSt = St dt + St dWt

(1)

where is the instantaneous expected capital gains rate that took away the interest rate and
insurance premium, and is the constant volatility.
Assumption 2[6] The shareholder pays an instantaneous interest of D0 to the lender,
and pays an instantaneous insurance premium of D0 to the insurer, where constant [0, 1] is
the instantaneous interest rate to be effectively paid on debt, and [0, 1] is the instantaneous
insurance premium rate for the insured bond. Any net cash outflows associated with interest
and insurance premium payments must be through the sale of firm assets.
1 Received

July 8, 2002; revised December 17, 2003. Financial support from the National Natural Science
Foundation of China (70271069).

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ACTA MATHEMATICA SCIENTIA

Vol.25 Ser.B

Endogenous Bankruptcy and Capital Structure

2.1

Structure of the Game

The structure of the game between firm and guarantor is summarized as follow. In the
first phase, the financing decision is made: The amount of debt, D0 , and the interest rate
and insurance premium rate ; Second phase, once this financing decision is down, the firm
chooses its investment program; Third phase, equity holders choose their bankruptcy strategy:
If St > SB , equity holders pay out D0 and D0 , and the game continue; If St SB the
bankruptcy occurs, equity holders get nothing, and a fraction (0, 1) of firms value is lost,
leaving guarantor with (1)SB , where SB denotes the asset value at which bankruptcy occurs,
and guarantor must pay D0 to lender, the game is over.
2.2 The Valuation of Guarantor and Firm
Once the game between firm and guarantor has been specified, the next step is to value
the players payoffs using option pricing theory, treating all the players decision variables as
parameters. We begin at the finally phase using backward method. Our main results are as
follow.
Theorem 1 Let F (St ) and D(St ) be the guarantor and bondholder claims at time t,then
F (St ) =

D0
St
St
(1 (
) ) + ((1 )SB D0 )(
) ,
r
SB
SB

(2)

D0
St
St
(1 (
) ) + D0 (
) ,
r
SB
SB

(3)

D(St ) =

where r is the risk-less interest rate, = 2r2 .

Proof Because of perpetual debt, firm bankruptcy becomes irrelevant and the debt is
risk-free when St becomes very large, and firm bankruptcy occurs when St falls under SB . So
Z
D0
F () =
(4)
D0 ert dt =
r
0
and
F (SB ) = (1 )SB D0 .

(5)

At time t, guarantor claim satisfies the following ordinary differential equation[6] :

1 2 2
St F + rSt F rF + D0 = 0.
2

(6)

Its general solution of this O.D.E is

F (St ) = 0 + 1 St + 2 St ,

(7)

where = 2r2 , and F (St ) must satisfy the boundary conditions (4) and (5). From (4), we have
1+

0
0 = D
D0 (1 + r )SB
. Therefore for the
r , 1 = 0. From (5), we have 2 = (1 )SB
1+

D0

0
value of guarantor claim F (St ) is F (St ) = r + ((1 )SB D0 (1 + r )SB
)St = D
r (1
St
St
( SB ) ) + ((1 )SB D0 )( SB ) . We obtain (2). At the same time, the claim of bondholder
satisfies the following ordinary differential equation: 21 2 St2 D + rSt D rD + D0 = 0 and
R
0
boundary conditions: D() = 0 D0 ert dt = D
r , and D(SB ) = D0 . Because the claim of
bondholder is D0 when the firm bankruptcy occurs, then we can obtain the expression (3).

No.2

245

Mei & Li: OPTIONS-GAME ANALYSIS FOR FIRM WITH INSURED DEBT

Note that if let p = 1 ( SSBt ) , q = ( SSBt ) , we call p or q the risk-neutral probability that
bankruptcy does not occur and occurs, respectively[6] , and p + q = 1. This result of Theorem
1 has an economic explanation: the value of guarantor claim equals the risk-free insurance
0
premium, D
r , times the risk-neutral probability that bankruptcy does not occur, p, plus the
value of the loss from asset liquidation in the event of bankruptcy, (1 )SB D0 , times the
risk-neutral probability of bankruptcy, q.
Theorem 2 Let W (St ) be the value of firm, then
W (St ) = St +

D0
St
St
(1 (
) ) SB (
) ,
r
SB
SB

(8)

where [0, 1] is the tax rate.

Proof Let the value of the tax deduction of interest payments be T B(St ) when firm
issued bond, and the value of bankruptcy costs be K(St ), then the total value of the firm,
W (St ), is[6]
W (St ) = St + T B(St ) K(St ).
(9)
We must price the tax deduction T B(St ) and bankruptcy costs K(St ) firstly. The value of tax
benefits, T B(St ), must satisfy the following ordinary differential equation:
1 2 2
St T B + rSt T B rT B + D0 = 0
2
R
and boundary conditions: T B(SB ) = 0 and T B() = 0 D0 ert dt =
obtain the solution of equation (10)
T B(St ) =

(10)
D0
r .

So, we can

D0
St
(1 (
) ).
r
SB

(11)

Next, we price the bankruptcy costs K(St ), which satisfies the following equation and boundary
conditions, similarly:
1 2 2
St K + rSt K rK = 0,
(12)
2
K(SB ) = SB ,
(13)
K() = 0.

(14)

We can obtain the solution of equation (12)

K(St ) = SB (

St
) .
SB

(15)

By using the boundary condition, the total value of the firm, W (St ) is
W (St ) = St + T B(St ) K(St ) = St +

D0
St
St
(1 (
) ) SB (
) .
r
SB
SB

We have completed the proof.

This result has an economic explanation too: the total value of the firm equals current
asset value plus the present value of the tax shields, times the risk-neutral probability p that
bankruptcy does not occur, minus the value SB , lost in the event of bankruptcy, times the
risk-neutral q probability of bankruptcy.

246

ACTA MATHEMATICA SCIENTIA

Vol.25 Ser.B

2.3

Endogenous Bankruptcy and Optimal Capital Structure

We have gained the value of guarantor claim and the total value of firm, now we can
0
determine the triggers bankruptcy SB and optimal debt D
Theorem 3 Let + . If assets value SB , which triggers bankruptcy, is chosen by
the equity holders so as to maximize the current value of the equity, then
SB =

D0 +
(
).
1+
r

(16)

Proof The value of equity, E(St ), is the total value of the firm, which should equal W (St )
less than the claims of guarantor and bondholder, F (St ) and D(St ), that is
E(St ) = W (St ) F (St ) D(St )
D0
St
St D0
St
(1 (
) ) SB (
)
(1 (
) )
r
SB
SB
r
SB
St D0
St
St
((1 )SB D0 )(
)
(1 (
) ) D0 (
)
SB
r
SB
SB
St
St

= St +
D0 (1 (
) ) SB (
) .
r
SB
SB
= St +

Because of one-order condition, we have

let

E(St )
SB

E(St )
SB

1
+
D0 St SB
r

(17)

St ( + 1)SB
,

= 0, yielding (16).
2

E(St )
2 +
= D0 St SB
< 0. That means
Also, we can test two-order condition S
2
r
B
that (16) is the optimal triggers bankruptcy which maximizes equity value. On the other
(St )
St
0
hand, W
= ( D
< 0, that means, we should choose SB = 0 when
SB
rSB + ( + 1))( SB )
maximizing social value or firm value.
At the time when the financing decision is made, the equity holders want to maximize the
net value of equity of their initial investment I(St ) = St F (St ) D(St ). We have
Theorem 4 Let + . When the debt that firm issued is insured bond, the optimal
face value of debt is

0 = St 1 + ( )1/ ( + A )1/ ,
D
A r(1 + )
r
1+

(18)

.
where A = +
r
Proof If initial investment I(St ) = St F (St ) D(St ), then the net value of equity is
E(St ) I(St ), therefore
E(St ) I(St ) = E(St ) (St F (St ) D(St )) = W (St ) St

+1
D0 (1 St SB
) St SB
r

D0 A
D0 A +1
=
D0 (1 St (
) ) St (
)
r
1+
1+

A
A
=
D0 D0+1 St (
) (
+
).
r
1+
r
1+
=

(19)

t )I(St ))
For maximizing this value, let (E(SD
= 0, we can obtain the optimal face value of insured
0

debt D0 , that is our theorem.

No.2

Mei & Li: OPTIONS-GAME ANALYSIS FOR FIRM WITH INSURED DEBT
D0 +
1+
r
r(1+)
.
(1)

If we let SB =
= +

D0
1 ,

247

then we can obtain the optimal insurance premium rate

3 Effects for Net Equity Value When Parameters Changing and Conclusion
We have obtained the formulas of endogenous bankruptcy trigger and optimal debt as
above, but these values are effected by the parameters, such as risk-free interest rate r, interest
rate of debt , tax rate , volatility and insurance premium rate . We know that the relation
0 and these parameters is nonlinear. It is difficult to analysis statically, but we can
between D
depicts these relations in figures by numerical computation. The results of numerical value
0.
show that equity holder can maximize the net value of equity by selecting SB and D
In this paper, we discuss the strategic model for insured bond of firm. First, we construct
a game between equity holders and guarantor when firms bond is insured against bankruptcy.
Second, we determine the players payoff by using the theory of options pricing. Then, we obtain
some interesting results about endogenous bankruptcy SB nd optimal face value of insured bond
0 , which develop the results of Anderson, R. W. and S. Sundaresan[4], Perraudin, W.[5] and
D
Ziegler, A.[6] . Finally, we illustrate the effects when parameters are changing.
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