Valuation of subordinated debt

[vjoyram]

Hi David
The notes in Chapter 18: Credit Derivatives (Stulz) present the subordinated debt as "what's left over". Wouldn't this term be more appropriate for the equity value? I can understand that from a mathematical point of view this can makes sense but I am not sure about the logic from an economic point. Could you please clarify? Many thanks

 

[David Harper CFA FRM]

Hi vjoyram,

From an economic viewpoint, yes, you are right: equity is the residual that is "left over."

From a mathematical viewpoint (Merton model), I posted this recently to summarize the treatment of subordinate/junior debt (source: Stulz). As you seem to know, the merton solution to subord debt is found by solving for the other two components (equity and senior debt), such that mathematically subord deb is "left over:" it is call option () - call option ().

David