Answer: Equity is a purchased call option on the assets

## Explanation In structural models of credit risk (like the Merton model), the relationship between debt and equity can be interpreted using option pricing theory: - **Equity is a purchased call option on the assets**: This is the correct interpretation. Shareholders have a call option on the firm's assets with a strike price equal to the face value of debt. If the asset value exceeds the debt value at maturity, shareholders exercise their option and keep the residual value. - **Debt is equivalent to a risk-free bond minus a put option**: The correct interpretation is that debt holders are long a risk-free bond and short a put option on the assets. This means they receive the risk-free payment but have sold downside protection to shareholders. - **Option B is incorrect** because it reverses the positions - debt is actually short a put option, not long one. - **Option C is incorrect** because it doesn't accurately represent the option relationships in structural models. The key insight is that shareholders have limited liability - they can't lose more than their investment, which gives them option-like characteristics.

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