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Pricing the Risk of Recovery in Default with APR Violation

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  • Haluk Unal
  • Dilip Madan
  • Levent Güntay
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    Abstract

    This paper proposes a simple approach to infer the risk neutral density of recovery rates implied by the prices of the debt securities of a firm. The proposed approach is independent of modeling default arrival rates and allows for the violation of absolute priority rule (APR). The paper demonstrates that a new statistic, the adjusted relative spread, captures risk neutralrecovery information in debt prices. Interest rates and firm tangible assets are shown to be significant determinants of the price of recovery. An application illustrates the pricing of credit derivatives written on the realized recovery rate.

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    File URL: http://fic.wharton.upenn.edu/fic/papers/02/0221.pdf
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    Bibliographic Info

    Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 02-21.

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    Date of creation: Aug 2001
    Date of revision:
    Handle: RePEc:wop:pennin:02-21

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    Related research

    Keywords: Recovery rates; APR violation; Risky debt pricing; Credit risk; Credit deriva-tives;

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    References

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    1. Eberhart, Allan C & Moore, William T & Roenfeldt, Rodney L, 1990. " Security Pricing and Deviations from the Absolute Priority Rule in Bankruptcy Proceedings," Journal of Finance, American Finance Association, vol. 45(5), pages 1457-69, December.
    2. Franks, Julian R. & Torous, Walter N., 1994. "A comparison of financial recontracting in distressed exchanges and chapter 11 reorganizations," Journal of Financial Economics, Elsevier, vol. 35(3), pages 349-370, June.
    3. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
    4. Stulz, ReneM. & Johnson, Herb, 1985. "An analysis of secured debt," Journal of Financial Economics, Elsevier, vol. 14(4), pages 501-521, December.
    5. Eberhart, Allan C & Sweeney, Richard J, 1992. " Does the Bond Market Predict Bankruptcy Settlements?," Journal of Finance, American Finance Association, vol. 47(3), pages 943-80, July.
    6. Madan, Dilip & Unal, Haluk, 2000. "A Two-Factor Hazard Rate Model for Pricing Risky Debt and the Term Structure of Credit Spreads," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(01), pages 43-65, March.
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    Cited by:
    1. Sanjiv Das, 2007. "Basel II: Correlation Related Issues," Journal of Financial Services Research, Springer, vol. 32(1), pages 17-38, October.

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