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uMtUnder breach of financial covenants, the barrier level is set as a multiple of the strike rate (face value of debt) that is greater than 1.)AB = Multiple of X, where multiple is > 1AB > XExample$Please enter the risk free rate (r):$Please enter the exercise price (X):Please enter the volatility:Please enter the maturity (T):y =N(y) =Value of down-and-in put =Value of Down-and-in put =
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"When AB is less than strike price:bUnder technical insolvency, the barrier level is set equal to the strike rate (face value of debt))AB = Multiple of X, where multiple is = 1AB = XuUnder technical insolvency (special), the barrier level is set as a multiple of the strike rate (face value of debt) that is less than 1.)AB = Multiple of X, where multiple is < 1AB < XExample:#Value of Risky Component of debt = DRisky debt has two components = Riskfree component + Risky component,Risk-free component = face value of debt (F)hRisky component = Default possibility of the leveraged firm, which is analagous to a form of put option.Thus, bondholder's payoff:Menu of default possibilities:Technical InsolvencyUDefault, if asset value falls below face value of debt at any time prior to maturity.Down-and-in put payoff = 7F = face value of debt = barrier level = exercise price/Thus, bondholder's payoffs can be rewritten as:Breach of financial covenantsDebt Ratio=,Possibility for Debt Ratio to go beyond 0.501) Total Assets decreasesCurrent ratio = 1/3 or 0.333Total Debt = 100Total Assets = 300Firm defaults if:$1) Assets decreases to less than 200eDown-and-in put option with barrier set at Asset value of 200 and exercise set at face value of debt.$Special case of Technical InsolvencykDefault, if asset value falls below face value of debt by a "certain degree" at any time prior to maturity.This case accounts for the "lag" usually associated with the time between default and when bondholders become aware of the situationDown-and-in put option with barrier set at a multiple of debt, where the multiple is less than 1 and the exercise is still face value of debt.e.g.,Face value of debt = 100mm,Thus, default if asset value drops below 90.JDown-and-in put option with barrier and exerciseset at face value of debt.0Total Debt/Total Asset
#e.g., Default, if Debt Ratio > 0.50, F, or F - Max(F - AT, 0) if default occurrsAT = asset value at maturity"(If At > Ad, then 0, MAX(F-AT, 0))
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MENU OF DEFAULT POSSIBILITIES APPENDIX B
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