Suppose the value of a hypothetical firm is 100 today, and it can increase to 140 or decrease to 80, over one year. The probabilities are 60% and 40%, respectively. The firm has two debt contracts outstanding in form of zero coupon bonds, maturing in one year. The first bond is the most senior debt contact (e.g. bank debt) with a face value of 20. The second bond is more junior with a face value of 90. Absolute priority is enforced, meaning the senior debt is repaid first in case of default before any payments are made to more junior investors. 

Assume that also tradable is a zero coupon bond without default risk, 100 face value paid in one year, and the riskless interest rate is 10% p.a, annually compounded. 

 

What is the credit spread of the more junior debt contract (expressed p.a. as annually compounded)? Format: Suppose you want to answer 8.50% p.a., enter 8.50

Answer rating: 100% (QA)

To calculate the credit spread of the more junior debt contract we need to compare its yield to matu... View the full answer