ACCA AFM Syllabus B. Advanced Investment Appraisal - BSOP and default risk - Notes 11 / 11
BSOP and default risk
The equity of a company can be seen as a call option on the assets of the company with an exercise price equal to the outstanding debt.
The role of BSOP model in the assessment of default risk is based on the limited liability property of equity investments.
The value of the firm’s equity can therefore be estimated using a variation of the Black-Scholes model for the valuation of a European call option.
The value of N(d1) shows how the value of equity changes when the value of the assets change.
This is the delta of the call option (delta is covered in more detail in Topic: Risks).
The value of N(d2) is the probability that a call option will be in the money at expiration.
In this case it is the probability that the value of the asset will exceed the outstanding debt,
The probability of default is therefore given by 1 – N(d2).