The Effect of Seniority on the Pricing and Risk of Corporate Debt
Master thesis
Permanent lenke
http://hdl.handle.net/11250/2565370Utgivelsesdato
2018Metadata
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Sammendrag
This thesis looks at what effect seniority has on corporate debt. I have used a theoretical approach and expanded the model developed by Merton (1974). My analysis is based on the corporate debt being pure discount bonds. By introducing a set of assumptions I have a basis for my valuation of the bonds. I present two propositions, and their proofs, for the pricing of two bonds with different seniority. Through the replicating portfolio method, I am able to derive a pricing equation of a third bond which is subordinated the two other bonds. With the insights from the pricing equations developed for these three bonds, I am able to create a general pricing formula of a bond based on its seniority. This model needs the same input in order to price the bonds, as that needed to price European options in the Black and Scholes (1973) option pricing model.
I find that the appropriate measure of the risk of the bonds is the standard deviation of the daily continuous returns of the bonds. This is due to the bonds being issued by the same company, and not regarded as part of a portfolio. Given my assumptions, subordinated bonds have a higher risk, measured in the standard deviation of daily returns, than any equivalent senior bond. This added risk calls for a higher yield to maturity for the subordinated bond. This result is shown through the presentation of two simulations.