Final answer:
A junior loan is subordinate to a senior or first loan, meaning it has lower priority for repayment in case of default. The value and risk associated with junior and senior loans vary based on factors like the borrower’s creditworthiness and market interest rates.
Step-by-step explanation:
The relationship between a junior loan and a senior or first loan refers to their positions in the hierarchy of debt repayment. When a borrower, like a family purchasing a house with a mortgage, defaults or goes into bankruptcy, senior loans are prioritized and repaid first before any junior loans. This hierarchical structure affects the perceived risk and the value of each loan from the lender's perspective. In the primary loan market, where loans are originated, a senior loan, often secured by collateral such as property, is deemed to have a lower risk because it has priority over other debts. Consequently, in the secondary loan market where loans are traded, a senior loan might be sold at a higher price than a junior loan due to this lower risk profile.
Certain factors such as a borrower’s creditworthiness, changes in interest rates, and the profits of a borrowing firm can affect a loan's value. For instance:
If a borrower has frequently been late on loan payments, it would decrease the loan's value as the likelihood of default is higher.
If market interest rates have increased, existing loans with lower rates become less attractive and are often sold for less.
If the borrower is a profitable firm, it implies a higher capability of repaying the loan, thus increasing the loan's market value.
Alternatively, if interest rates have fallen, existing loans with higher rates become more valuable.