Applications of option theory to the analysis of debt contracts.

Summary We develop three applications of option theory to problems specific to the writing and valuation of debt contracts. First, we systematically establish the correspondence between the type of debt contract chosen by the firm and the optional form of the resulting stock. This optional form is an issue in negotiations between creditors and shareholders in order to limit the incentive of the latter to increase the firm's risk. We study different clauses, as well as some ways for shareholders to circumvent the debt contract, that make the stock a complex option. Second, we evaluate the securities issued by firms when bankruptcy proceedings are considered. The focus is on U.S. legislation, but the model is also applied to the French situation in a case study. The impacts of the bankruptcy procedure on the firm's financial decisions are that (I) the optimal leverage decreases when the firm is entitled to an observation period, (II) if the assignees consider reorganizing the firm, the shareholders have an incentive to declare an early default, (III) for a firm with optimal leverage, the default risk premia are independent of the bankruptcy procedure. Third, we examine the renegotiation of the sovereign debt contract which consists in reducing the nominal value of the debt or extending its maturity. We show that there is a renegotiation space where both parties share a surplus. Our model explains some stylized facts about sovereign debt, namely that (I) risky or highly indebted countries get financing, (II) debt reduction can be beneficial to both parties, as well as (III) the deal combining debt reduction and rescheduling of a small part of the nominal.