Debt Subordination and The Pricing of Credit Default Swaps

TL;DR

This paper models how debt subordination affects credit default swap pricing by analyzing the relationship between recovery fractions and default probabilities within a first passage default framework.

Contribution

It introduces a model linking debt subordination levels to recovery fractions and default probabilities, enhancing understanding of CDS spread dynamics.

Findings

Recovery fractions depend on default threshold fluctuations.

Subordination influences the correlation between default probability and recovery.

Debt cushion impacts CDS par spreads.

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.