Debt Subordination and the Pricing of Credit Default Swaps

Cal Tech Working Paper No. CALT-68-2415

10 Pages Posted: 30 Jan 2003

See all articles by Peter B. Lee

Peter B. Lee

Lehman Brothers, New York

Mark B. Wise

California Institute of Technology

Vineer Bhansali

LongTail Alpha, LLC

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 Ri that is greater or less than R depending on its level of subordination. In general the Ri 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 Ri 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 Ri(R) and explore how correlations between the default probability and the recovery fractions Ri(R) influence the par spreads for credit default swaps. This scenario captures the effect of debt cushion on recovery fractions.

Keywords: Credit Default Swaps, Debt Subordination

JEL Classification: G10, G12

Suggested Citation

Lee, Peter Byungho and Wise, Mark B. and Bhansali, Vineer, Debt Subordination and the Pricing of Credit Default Swaps. Cal Tech Working Paper No. CALT-68-2415, Available at SSRN: https://ssrn.com/abstract=360520 or http://dx.doi.org/10.2139/ssrn.360520

Peter Byungho Lee

Lehman Brothers, New York ( email )

745 Seventh Avenue
New York, NY 10019
United States

Mark B. Wise (Contact Author)

California Institute of Technology ( email )

Pasadena, CA 91125
United States
626-395-6687 (Phone)
626-568-8473 (Fax)

Vineer Bhansali

LongTail Alpha, LLC ( email )

500 Newport Center Drive
Suite 820
Newport Beach, CA 92660
United States

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