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Estimating Implied Recovery Rates from the Term Structure of CDS Spreads

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  • Marcin Jaskowski

    (Erasmus University Rotterdam)

  • Michael McAleer

    (Erasmus University Rotterdam, Kyoto University, Japan, and Complutense University of Madrid, Spain)

Abstract

Credit risk models should reflect the observation that the relevant value of collateral is generally not the average value of the asset over all possible states of nature. In most cases, the relevant value of collateral for the lender is its secondary market value in bad states of nature, where marginal utilities are high. Although the negative correlation between recovery rates and default probabilities is well documented, the majority of pricing models does not allow for correlation between the two. In this paper, we propose a relatively parsimonious reduced-form continuous time model that estimates expected recovery rates and default probabilities from the term structure of CDS spreads. The parameters of the model and latent factors driving recovery risk and default risk are estimated using a Bayesian MCMC algorithm. We find that the Bayesian deviance information criterion (DIC) favors the model with stochastic recovery over constant recovery. We also observe that for companies with a good rating, implied constant recovery rates do not differ much from stochastic recovery. However, if a company is very risky, then forward stochastic recovery rates are significantly lower at longer maturities.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 13-005/III.

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Date of creation: 07 Jan 2013
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Handle: RePEc:dgr:uvatin:20130005

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Web page: http://www.tinbergen.nl

Related research

Keywords: Constant recovery; stochastic recovery; implied recovery rate; term structure; CDS spreads;

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  1. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  2. 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.
  3. Das, Sanjiv R. & Hanouna, Paul, 2009. "Implied recovery," Journal of Economic Dynamics and Control, Elsevier, vol. 33(11), pages 1837-1857, November.
  4. Efraim Benmelech & Nittai K. Bergman, 2011. "Bankruptcy and the Collateral Channel," Journal of Finance, American Finance Association, vol. 66(2), pages 337-378, 04.
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  7. Jun Pan & Kenneth J. Singleton, 2008. "Default and Recovery Implicit in the Term Structure of Sovereign "CDS" Spreads," Journal of Finance, American Finance Association, vol. 63(5), pages 2345-2384, October.
  8. David J. Spiegelhalter & Nicola G. Best & Bradley P. Carlin & Angelika van der Linde, 2002. "Bayesian measures of model complexity and fit," Journal of the Royal Statistical Society Series B, Royal Statistical Society, vol. 64(4), pages 583-639.
  9. Schneider, Paul & Sögner, Leopold & Veža, Tanja, 2011. "The Economic Role of Jumps and Recovery Rates in the Market for Corporate Default Risk," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(06), pages 1517-1547, January.
  10. 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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