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Dependence of defaults and recoveries in structural credit risk models

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  • Rudi Sch\"afer
  • Alexander F. R. Koivusalo
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    Abstract

    The current research on credit risk is primarily focused on modeling default probabilities. Recovery rates are often treated as an afterthought; they are modeled independently, in many cases they are even assumed constant. This is despite of their pronounced effect on the tail of the loss distribution. Here, we take a step back, historically, and start again from the Merton model, where defaults and recoveries are both determined by an underlying process. Hence, they are intrinsically connected. For the diffusion process, we can derive the functional relation between expected recovery rate and default probability. This relation depends on a single parameter only. In Monte Carlo simulations we find that the same functional dependence also holds for jump-diffusion and GARCH processes. We discuss how to incorporate this structural recovery rate into reduced form models, in order to restore essential structural information which is usually neglected in the reduced-form approach.

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    File URL: http://arxiv.org/pdf/1102.3150
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1102.3150.

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    Date of creation: Feb 2011
    Date of revision: Mar 2011
    Publication status: Published in Economic Modelling 30 (2013) 1-9
    Handle: RePEc:arx:papers:1102.3150

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    Web page: http://arxiv.org/

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    Cited by:
    1. Alexander Becker & Alexander F. R. Koivusalo & Rudi Sch\"afer, 2012. "Empirical Evidence for the Structural Recovery Model," Papers 1203.3188, arXiv.org.

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