Credit Risk Management Practice Exam

What happens to subordinated debt when a firm is in distress according to the Merton model?

1. It behaves like equity

2. It has no value

3. It is treated the same as secured debt

4. It always appreciates in value

The correct answer is: It behaves like equity

Subordinated debt is a type of debt that ranks below other forms of debt in terms of claims on the firm's assets in the event of liquidation. According to the Merton model, which is a structural model of credit risk, subordinated debt is treated similarly to equity when a firm is in distress. This behavior arises because the value of subordinated debt is contingent upon the performance of the firm. In times of financial hardship, if the firm's assets fall below the total value of its debts, subordinated debt holders are last in line to be paid after senior creditors. As a result, in distress scenarios, the potential for recovery becomes highly uncertain, leading to a situation where subordinated debt resembles equity, which is also risky and dependent on the firm’s future performance. When the probabilities of default increase, subordinated debt holders may experience losses akin to equity holders, reinforcing the idea that in distressed situations, the risk profiles align. On the other hand, the other options describe scenarios that do not accurately reflect the characteristics of subordinated debt in distress. The notion that subordinated debt has no value misrepresents its inherent risk; while it may have diminished value, it does not automatically convert to zero. Treating it the same as secured debt