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Pricing of debt and equity in a financial network with comonotonic endowments

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  • Tathagata Banerjee
  • Zachary Feinstein

Abstract

In this paper we present formulas for the valuation of debt and equity of firms in a financial network under comonotonic endowments. We demonstrate that the comonotonic setting provides a lower bound and Jensen's inequality provides an upper bound to the price of debt under Eisenberg-Noe financial networks with bankruptcy costs. Such financial networks encode the interconnection of firms through debt claims. The proposed pricing formulas consider the realized, endogenous, recovery rate on debt claims. Special consideration is given to the CAPM setting in which firms invest in correlated portfolios so as to provide analytical stress testing formulas. We endogenously construct the comonotonic endowment setting from a equity maximizing standpoint with capital transfers. We conclude by, numerically, comparing the network valuation problem with two single firm baseline heuristics which can, respectively, approximate the price of debt and equity.

Suggested Citation

  • Tathagata Banerjee & Zachary Feinstein, 2018. "Pricing of debt and equity in a financial network with comonotonic endowments," Papers 1810.01372, arXiv.org, revised Sep 2021.
    • Handle: RePEc:arx:papers:1810.01372
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    3. Zachary Feinstein & Andreas Sojmark, 2020. "Dynamic Default Contagion in Heterogeneous Interbank Systems," Papers 2010.15254, arXiv.org, revised Jul 2021.

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