Recovery rates, default probabilities, and the credit cycle
AbstractIn 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 InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 34 (2010)
Issue (Month): 4 (April)
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Web page: http://www.elsevier.com/locate/jbf
Credit Recovery rate Default probability Business cycle Capital requirements Markov chain;
Other versions of this item:
- Carlos González-Aguado & Max Bruche, 2006. "Recovery Rates, Default Probabilities and the Credit Cycle," FMG Discussion Papers dp572, Financial Markets Group.
- Max Bruche & Carlos González Aguado, 2006. "Recovery Rates, Default Probabilities And The Credit Cycle," Working Papers wp2006_0612, CEMFI.
- Max Bruche & Carlos Gonzalez-Aguado, 2006. "Recovery rates, default probabilities and the credit cycle," LSE Research Online Documents on Economics 24524, London School of Economics and Political Science, LSE Library.
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
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