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Pricing Options with Extendible Maturities: Analysis and Applications
Author(s) -
LONGSTAFF FRANCIS A.
Publication year - 1990
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1990.tb05113.x
Subject(s) - valuation (finance) , embedded option , maturity (psychological) , shareholder , default , incentive , equity (law) , valuation of options , debt , asian option , economics , extension (predicate logic) , business , dividend , financial economics , actuarial science , microeconomics , computer science , finance , psychology , developmental psychology , corporate governance , programming language , political science , law
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.