Stochastic equity volatility related to the leverage effect.

Bensoussan, Alain; Crouhy, Michel; Galai, Dan

We propose a general framework to model equity volatility for a firm financed by equity and additional nonequity sources of funds. The stochastic nature of equity volatility is endogenous, and comes from the impact of a change in the value of the firm's assets on the financial leverage. We first present the basic model, which is an extension of the Black-Scholes model, to value corporate securities. Second, we show for the first time in the option literature, that instantaneous equity volatility is a solution of a partial differential equation similar to Black-Scholes', although it is non-linear and in general does not have any analytical solution. However, analytical approximations for equity volatility are proposed for different capital structures: (1) equity and debt, (2) equity and warrants, and (3) equity, debt and warrants. They are shown to be very accurate.

CORPORATE finance; EQUITY (Law); FINANCIAL leverage; OPTIONS (Finance)

Applied Mathematical Finance, 1994, Vol 1, Issue 1, p63

1350-486X

Academic Journal

10.1080/13504869400000004