Market Valuation of Illiquid Debt and Implications for Conflicts Among Creditors

Abstract

We develop a formula for the market value of debt when the borrower'srepayment capacity varies stochastically and shortfalls are rolled over.The value of a marginal dollar of nominal claim is an S-shaped functionof the ratio of the repayment capacity to the amount of nominal debt.Shifts of this curve are examined in response to changes in theunderlying parameters. The calculations bring out conflicts of interestamong lenders of differing degrees of seniority. Most surprisingly,junior creditors gain when the loan is rescheduled on terms morefavorable to the debtor.