The debt and equity linkage and the valuation of credit derivatives

Sean C Keenan, Jorge R Sobehart and Terry L Benzschawel

In their seminal article, Modigliani and Miller (1958) presented a theory that became a cornerstone of modern finance. Their paper explained the indeterminacy of corporate capital structure under certain idealised conditions. Several of these conditions are simplifying assumptions that could easily be relaxed. But crucial to their analysis is the assumption of complete contingent claims markets. Under these conditions, both investors and managers are indifferent as to whether firms finance projects using debt or equity, and projects expected to add value to future states of the world will be financed by one means or the other. All claims are contingent in a probabilistic sense, and corporate default risk is efficiently priced through consensus expectations about the relative likelihood of future states of the world.²²See Arrow (1964). Credit derivatives per se are unnecessary in this scenario, since each investor creates a portfolio of contingent claims diversified over all possible future world conditions. In simple terms, each investor holds a portfolio of assets, with each portfolio’s return tied to the returns for all projects, in some specific future state of the world.

While