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Debt Subordination and The Pricing of Credit Default Swaps

Peter B. Lee·Mark B. Wise·Vineer Bhansali
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Abstract

First passage models, where corporate assets undergo a random walk and default occurs if the assets fall below a threshold, provide an attractive framework for modeling the default process. Recently such models have been generalized to allow a fluctuating default threshold or equivalently a fluctuating total recovery fraction $R$. For a given company a particular type of debt has a recovery fraction $R_i$ that is greater or less than $R$ depending on its level of subordination. In general the $R_i$ are functions of $R$ and since, in models with a fluctuating default threshold, the probability of default depends on $R$ there are correlations between the recovery fractions $R_i$ and the probability of default. We find, using a simple scenario where debt of type $i$ is subordinate to debt of type $i-1$, the functional dependence $R_i(R)$ and explore how correlations between the default probability and the recovery fractions $R_i(R)$ influence the par spreads for credit default swaps. This scenario captures the effect of debt cushion on recovery fractions.

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Peter B. Lee, Mark B. Wise, Vineer Bhansali. 2003-01-22. Debt Subordination and The Pricing of Credit Default Swaps. https://arxiv.org/abs/cond-mat/0212349

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