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Pricing Options with Extendible Maturities: Analysis and Applications

98 citations0/0 files storedThe Journal of Finance

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Stochastic processes and financial applications Corporate Insolvency and Governance Capital Investment and Risk Analysis

Abstract

ABSTRACT Many common types of financial contracts incorporate options with extendible maturities. This paper derives closed‐form expressions for options that can be extended by the optionholder and presents a number of applications including the valuation of American options with stochastic dividends, junk bonds, and shared‐equity mortgages. We also derive closed‐form expressions for writer‐extendible options and discuss the writer's economic incentives for extending an out‐of‐the‐money option. We apply these results to show that corporate debtholders have a strong incentive to extend the maturity of defaulting debt if there are liquidation costs. We model and solve the debtholders' optimal extension problem and show that the possibility of an extension can induce shareholders in highly levered firms to accept negative NPV projects.

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References

1973The Pricing of Options and Corporate Liabilities 1974ON THE PRICING OF CORPORATE DEBT: THE RISK STRUCTURE OF INTEREST RATES*1973Theory of Rational Option Pricing 2005Theory of rational option pricing 2003Stochastic Differential Equations 1976The valuation of options for alternative stochastic processes 1976Stochastic Differential Equations and Applications 1979The valuation of compound options

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