Mengchao Essay

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REV. JANUARY 29, 2004

TEACHING NOTE

op yo Arley Merchandise Corporation
Objectives and Synopsis

The Arley Merchandise Corporation represents an example of a corporate issuer attempting to realize a higher price for its common shares by offering potential investors a “money-back guarantee.” In this instance, the guarantee takes the form of a European put option (called a “Right” in the case) which is exercisable two years from the date of issue.
In some ways, the case represents an example of the design of a security to overcome information asymmetries in the capital markets. Arley's management has projected a highly confident picture to the underwriters that the company's future profit
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To correctly value the put option requires a model of default risk in addition to the underlying equity risk.2

Do

Luckily, in this instance, the above put-call parity relation provides a simple and indirect way of valuing the right, since it separates stock price risk from default risk. There is little, if any, default risk associated with the call option, as holders will wish to exercise their right at a time when the firm

1 The put and call values are almost equal since the strike price of $8 is very close to the beginning stock price of $6.50 plus

riskless interest.
2 See, for example, H. Johnson and R. Stultz (1987), “The pricing of options with default risk,” Journal of Finance, 42, 267-280.

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Teaching Note—Arley Merchandise Corporation

is doing well. It also is generally much easier for a firm to fulfill an obligation to issue equity than to redeem shares for cash. Thus, standard Black-Scholes can be applied in valuing the call option.

What remains is to value the zero-coupon note. This is a question purely of credit risk, the price of which can be approximated using Exhibit 5, which contains yields on straight debt of lowrated issuers comparable to Arley. The issues in the Exhibit are priced at spreads as

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