Senior debt & Subordinate Debt

[Sunil Natarajan]

Hi David,
In Stulz reading of Credit Risks and Derivatives . He mentions there is ambiguity in subordinate debt value as firm value increases.
Could you please explain what exactly happens when firm value is in distress to senior debt,subordinated debt and equity and similarly when firm value is not in distress. Does time to maturity also affects subordinated debt value.To what extent as per AIMS we are required to know this concept for FRM exam.

Regards,
Sunil

 

[David Harper CFA FRM]

sridhar,

If you'd like you can see this XLS (I'll blog it tomorrow)
This captures the subordinate debt per Merton Model. Re the AIMs and how much you need to know, i feel it is difficult to say on this on ("Explain the differences between valuing senior and subordinated debt using a contingent claim approach")

The key issue is that the subordinated debt, in the Merton approach, is long a call and short a call such that increasing volatility is ambiguous.

Re the maturity, if you look at the XLS, i divided into high value firm and low value firm (using Stulz') numbers and they are indeed different

David