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Dependence of defaults and recoveries in structural credit risk models

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  • Rudi Schafer
  • Alexander F. R. Koivusalo

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.

Suggested Citation

  • Rudi Schafer & Alexander F. R. Koivusalo, 2011. "Dependence of defaults and recoveries in structural credit risk models," Papers 1102.3150, arXiv.org, revised Mar 2011.
  • Handle: RePEc:arx:papers:1102.3150
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    File URL: http://arxiv.org/pdf/1102.3150
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    References listed on IDEAS

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    1. Lux, Thomas, 1998. "The socio-economic dynamics of speculative markets: interacting agents, chaos, and the fat tails of return distributions," Journal of Economic Behavior & Organization, Elsevier, vol. 33(2), pages 143-165, January.
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    Cited by:

    1. Alexander Becker & Alexander F. R. Koivusalo & Rudi Schafer, 2012. "Empirical Evidence for the Structural Recovery Model," Papers 1203.3188, arXiv.org.

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