The Leland Model as a Consistent Framework for Analytic Valuation of Equity and Options on Equity

Abstract

Although there are many well-established models for valuing corporate debt and equity, option pricing literature rarely takes these models as their starting point. This happens in part because such models value equity as an option on the firm’s assets, and options on equity then become compound options that cannot generally be priced analytically. In this article, we present a consistent and unified framework for valuing equity and options on equity within the 1994 Leland model. We show that it is possible to value not only European call and put options but also exotic options such as barriers and lookbacks in closed form. Moreover, we show that the model produces an implied volatility skew that is typically observed in the equity options market.