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Recovery rates, default probabilities, and the credit cycle

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  • Bruche, Max
  • González-Aguado, Carlos

Abstract

In recessions, the number of defaulting firms rises. On top of this, the average amount recovered on the bonds of defaulting firms tends to decrease. This paper proposes an econometric model in which this joint time-variation in default rates and recovery rate distributions is driven by an unobserved Markov chain, which we interpret as the "credit cycle". This model is shown to fit better than models in which this joint time-variation is driven by observed macroeconomic variables. We use the model to quantitatively assess the importance of allowing for systematic time-variation in recovery rates, which is often ignored in risk management and pricing models.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 34 (2010)
Issue (Month): 4 (April)
Pages: 754-764
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Handle: RePEc:eee:jbfina:v:34:y:2010:i:4:p:754-764

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For corrections or technical questions regarding this item, or to correct its listing, contact: (Jeroen Loos).

Related research

Keywords: Credit Recovery rate Default probability Business cycle Capital requirements Markov chain;

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References

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  1. Diebold, Francis X & Gunther, Todd A & Tay, Anthony S, 1998. "Evaluating Density Forecasts with Applications to Financial Risk Management," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 863-83, November.
  2. Acharya, Viral V. & Bharath, Sreedhar T. & Srinivasan, Anand, 2007. "Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries," Journal of Financial Economics, Elsevier, vol. 85(3), pages 787-821, September.
  3. Long Chen & Pierre Collin-Dufresne & Robert S. Goldstein, 2009. "On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 22(9), pages 3367-3409, September.
  4. Olivier RENAULT & Olivier SCAILLET, 2003. "On the Way to Recovery: A Nonparametric Bias Free Estimation of Recovery Rate Densities," FAME Research Paper Series rp83, International Center for Financial Asset Management and Engineering.
  5. Edward I. Altman & Brooks Brady & Andrea Resti & Andrea Sironi, 2005. "The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
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Citations

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Cited by:
  1. Juan Sole & Alicia Novoa & Jodi Scarlata, 2009. "Procyclicality and Fair Value Accounting," IMF Working Papers 09/39, International Monetary Fund.
  2. Rafael Repullo & Javier Suarez, 2008. "The Procyclical Effects Of Basel Ii," Working Papers wp2008_0809, CEMFI.
  3. Stefan Kerbl & Michael Sigmund, 2011. "What Drives Aggregate Credit Risk?," Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank), issue 22, pages 72-87, December.
  4. Andrea Cipollini & Giuseppe Missaglia, 2008. "Measuring bank capital requirements through Dynamic Factor analysis," Center for Economic Research (RECent) 010, University of Modena and Reggio E., Dept. of Economics.
  5. Balázs Zsámboki, 2007. "Basel II and financial stability: An investigation of sensitivity and cyclicality of capital requirements based on QIS 5," MNB Occasional Papers 2007/67, Magyar Nemzeti Bank (the central bank of Hungary).
  6. Diana Bonfim & Daniel Dias & Christine Richmond, 2011. "What Happens After Default? Stylized Facts on Access to Credit," Working Papers w201101, Banco de Portugal, Economics and Research Department.
  7. Iman van Lelyveld & Marco Spaltro, 2011. "Coordinating Bank Failure Costs and Financial Stability," DNB Working Papers 306, Netherlands Central Bank, Research Department.
  8. Richard J Martin, 2011. "A CDS Option Miscellany," Quantitative Finance Papers 1201.0111, arXiv.org.
  9. Gabriel Jiménez & Javier Mencía, 2007. "Modeling the distribution of credit losses with observable and latent factors," Banco de España Working Papers 0709, Banco de España.
  10. Ethan Cohen-Cole, 2007. "Asset liquidity, debt valuation and credit risk," Quantitative Analysis Unit Working Paper QAU07-5, Federal Reserve Bank of Boston.
  11. Gunes Kamber & Christoph Thoenissen, 2011. " The financial accelerator and monetary policy rules," CDMA Working Paper Series 1115, Centre for Dynamic Macroeconomic Analysis.
  12. Zhang, Zhipeng, 2009. "Who Pulls the Plug? Theory and Evidence on Corporate Bankruptcy Decisions," MPRA Paper 17676, University Library of Munich, Germany, revised 05 Oct 2009.
  13. Gábor Vadas, 2007. "Wealth portfolio of Hungarian households – Urban legends and facts," MNB Occasional Papers 2007/68, Magyar Nemzeti Bank (the central bank of Hungary).
  14. Joan Llull, 2008. "The Impact Of Immigration On Productivity," Working Papers wp2008_0802, CEMFI.
  15. Mathieu Gatumel & Florian Ielpo, 2011. "The Number of Regimes Across Asset Returns: Identification and Economic Value," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00658540, HAL.

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