Balance Sheet Effects on Option Pricing

A balance sheet structure including fixed assets, net working capital and risky long-term debt leads to a model for option pricing of the firm’s equity. Each of the financial components constitutes a source of risk. A hedge based on three distinct options and the stock enables risk neutral valuation and avoids the problems of lack of tradability of the assets and market incompleteness reflected by the market price of risk. A two-option hedge when debt and working capital are combined leads to a unique partial differential equation yielding the call price. The combination of fixed volatility components exhibits non-constancy in stock return volatility, appearing to be stochastic volatility.