The informational content of subordinated debt and equity prices in the presence of bankruptcy costs

The paper extends the contingent valuation framework of Black and Cox [J. Finance 31(2) (1976) 351] to value subordinated debt by explicitly incorporating bankruptcy costs in the model. We show that the information from subordinated debt prices is complementary to the information from the equity prices only when the bankruptcy costs are taken into account. In fact, the joint use of equity and subordinated debt prices can provide information on magnitude of expected bankruptcy costs. Knowing the magnitude of expected bankruptcy costs is necessary for calculating variables underlying policy objectives. In particular, it is illustrated that the value of expected liability of a deposit insurer would be underestimated if the bankruptcy costs were not taken into account.