
 Debt Subordination and The Pricing of Credit Default Swaps by Peter B. Lee of the California Institute of Technology, January 22, 2003 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. 