Hi All, I just wanted to verify something. For the call option used to calculate the value of the junior debt, I see where the Examiners used C1+C2 which is the TOTAL of the debt as the strike price. If it were a typical debt/equity question, only the value of the debt would be used. So do we use the total (which includes the value of the junior debt) because the junior debt is a form of debt and as such we can't look at it like it's equity even though it's paid after the senior debt? Thanks much.
From the shareholders' viewpoint, they need to pay off both loans before they receive anything and so the strike price for their option on the firm's assets is L1+L2. Their holding is like a call option on the firm's assets, with this strike price. Both loans are fundamentally different from the equity holding in that there's a maximum amount that will be received if things go well, but a risk that this amount will be reduced. The senior loanholders' holding is like a risk-free ZCB plus a short holding in a put option with strike L1. (If the firm's assets are at least L1 then this loan is repaid in full and there's no more upside on the loan.) The junior loanholders' holding is like a risk-free ZCB plus a short holding in a put option with strike L1+L2 less the senior loanholder's holding. (If the firm's assets are at least L1+L2 then this loan is repaid in full and there's no more upside on the loan.)
