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Systematic Risk in Recovery Rates: An Empirical Analysis of US Corporate Credit Exposures

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  • Düllmann, Klaus
  • Trapp, Monika
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    Abstract

    This paper presents an analytical and empirical analysis of a parsimonious model framework that accounts for a dependence of bond and bank loan recoveries on systematic risk. We extend the single risk factor model by assuming that the recovery rates also depend on this risk factor and follow a logit?normal distribution. The results are compared with those of two related models, suggested in Frye (2000) and Pykhtin (2003), which pose the assumption of a normal and a log-normal distribution of recovery rates. We provide estimators of the parameters of the asset value process and their standard errors in closed form. For the parameters of the recovery rate distribution we also provide closed-form solutions of a feasible maximum-likelihood estimator for the three models. The model parameters are estimated from default frequencies and recovery rates that were extracted from a bond and loan database of Standard&Poor's. We estimate the correlation between recovery rates and the systematic risk factor and determine the impact on economic capital. Furthermore, the impact of measuring recovery rates from market prices at default and from prices at emergence from default is analysed. As a robustness check for the empirical results of the maximum-likelihood estimation method we also employ a method-of-moments. Our empirical results indicate that systematic risk is a major factor influencing recovery rates. The calculation of a default?weighted recovery rate without further consideration of this factor may lead to downward-biased estimates of economic capital. Recovery rates measured from market prices at default are generally lower and more sensitive to changes of the systematic risk factor than are recovery rates determined at emergence from default. The choice between these two measurement methods has a stronger impact on the expected recovery rates and the economic capital than introducing a dependency of recovery rates on systematic risk in the single risk factor model. --

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    Bibliographic Info

    Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 2: Banking and Financial Studies with number 2004,02.

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    Date of creation: 2004
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    Handle: RePEc:zbw:bubdp2:4251

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    Related research

    Keywords: asset correlation; New Basel Accord; recovery rate; LGD; recovery correlation; single risk factor model;

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    References

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    1. M. Ayhan Kose & Christopher Otrok & Charles H. Whiteman, 2003. "International Business Cycles: World, Region, and Country-Specific Factors," American Economic Review, American Economic Association, American Economic Association, vol. 93(4), pages 1216-1239, September.
    2. Acharya, Viral V & Bharath, Sreedhar T & Srinivasan, Anand, 2003. "Understanding the Recovery Rates on Defaulted Securities," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4098, C.E.P.R. Discussion Papers.
    3. 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, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
    4. Michael B. Gordy, 2002. "A risk-factor model foundation for ratings-based bank capital rules," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2002-55, Board of Governors of the Federal Reserve System (U.S.).
    5. Dietsch, Michel & Petey, Joel, 2004. "Should SME exposures be treated as retail or corporate exposures? A comparative analysis of default probabilities and asset correlations in French and German SMEs," Journal of Banking & Finance, Elsevier, Elsevier, vol. 28(4), pages 773-788, April.
    6. Philipp J. Schönbucher, 2000. "Factor Models for Portofolio Credit Risk," Bonn Econ Discussion Papers, University of Bonn, Germany bgse16_2001, University of Bonn, Germany.
    7. Andrew J. Filardo, 1997. "Cyclical implications of the declining manufacturing employment share," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 63-87.
    8. Jon Frye, 2000. "Depressing recoveries," Emerging Issues, Federal Reserve Bank of Chicago, Federal Reserve Bank of Chicago, issue Oct.
    9. Lawrence J. Cristiano & Terry J. Fitzgerald, 1998. "The business cycle: it's still a puzzle," Economic Perspectives, Federal Reserve Bank of Chicago, Federal Reserve Bank of Chicago, issue Q IV, pages 56-83.
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    Cited by:
    1. Zhang, Zhipeng, 2009. "Recovery Rates and Macroeconomic Conditions: The Role of Loan Covenants," MPRA Paper 17521, University Library of Munich, Germany.
    2. Schläfer, Timo & Uhrig-Homburg, Marliese, 2014. "Is recovery risk priced?," Journal of Banking & Finance, Elsevier, Elsevier, vol. 40(C), pages 257-270.
    3. Li, Hui, 2010. "Downturn LGD: A Spot Recovery Approach," MPRA Paper 20010, University Library of Munich, Germany.
    4. Morone, Marco & Cornaglia, Anna, 2010. "An econometric model to quantify benchmark downturn LGD on residential mortgages," MPRA Paper 25588, University Library of Munich, Germany.
    5. Düllmann, Klaus & Kunisch, Michael & Küll, Jonathan, 2008. "Estimating asset correlations from stock prices or default rates: which method is superior?," Discussion Paper Series 2: Banking and Financial Studies 2008,04, Deutsche Bundesbank, Research Centre.
    6. Stefano Caselli & Stefano Gatti & Francesca Querci, 2008. "The Sensitivity of the Loss Given Default Rate to Systematic Risk: New Empirical Evidence on Bank Loans," Journal of Financial Services Research, Springer, Springer, vol. 34(1), pages 1-34, August.
    7. Klaus Rheinberger & Martin Summer, 2008. "Credit portfolio risk and asset price cycles," Computational Management Science, Springer, Springer, vol. 5(4), pages 337-354, October.

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