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Understanding the role of recovery in default risk models: empirical comparisons and implied recovery rates


  • Gurdip Bakshi
  • Dilip B. Madan
  • Frank X. Zhang


This article presents a framework for modeling defaultable debt under alternative recovery conventions (for a wide class of processes describing recovery rates and default probability). These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be utilized to invert the market expectation of recovery rates implicit in bond prices. Among potential applications, the framework can be used for pricing and hedging credit derivatives that are contingent on the default event and/or recovery levels. Empirical implementation of these models suggests two central findings. First, the recovery concept that specifies recovery as a fraction of the discounted par value has broader empirical support. Second, parametric debt valuation models can provide a useful assessment of recovery rates embedded in bond prices. This article has attempted to model recovery and comprehend their impact on debt values.

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  • Gurdip Bakshi & Dilip B. Madan & Frank X. Zhang, 2001. "Understanding the role of recovery in default risk models: empirical comparisons and implied recovery rates," Finance and Economics Discussion Series 2001-37, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2001-37

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    References listed on IDEAS

    1. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-1227, July.
    2. Hua He, 2000. "Modeling Term Structures of Swap Spreads," Yale School of Management Working Papers ysm150, Yale School of Management, revised 01 Mar 2001.
    3. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
    4. Dilip Madan & Haluk Unal, 1996. "Pricing the Risks of Default," Center for Financial Institutions Working Papers 94-16, Wharton School Center for Financial Institutions, University of Pennsylvania.
    5. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters,in: Theory Of Valuation, chapter 5, pages 129-164 World Scientific Publishing Co. Pte. Ltd..
    6. Pierre Collin-Dufresne, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, vol. 56(3), pages 1095-1115, June.
    7. Bakshi, Gurdip & Madan, Dilip, 2000. "Spanning and derivative-security valuation," Journal of Financial Economics, Elsevier, vol. 55(2), pages 205-238, February.
    8. Gurdip Bakshi & Nikunj Kapadia & Dilip Madan, 2003. "Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 101-143.
    9. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
    10. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, vol. 52(4), pages 1287-1321, September.
    11. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409 World Scientific Publishing Co. Pte. Ltd..
    12. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
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    Cited by:

    1. Pesaran, M. Hashem & Schuermann, Til & Treutler, Bjorn-Jakob & Weiner, Scott M., 2006. "Macroeconomic Dynamics and Credit Risk: A Global Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1211-1261, August.
    2. Frank X. Zhang, 2003. "What did the credit market expect of Argentina default? Evidence from default swap data," Finance and Economics Discussion Series 2003-25, Board of Governors of the Federal Reserve System (U.S.).
    3. Jochen R. Andritzky, 2004. "Implied Default Probabilities and Default Recovery Ratios: An Analysis of Argentine Eurobonds 2000-2002," Econometric Society 2004 Far Eastern Meetings 500, Econometric Society.
    4. Klaus Rheinberger & Martin Summer, 2008. "Credit portfolio risk and asset price cycles," Computational Management Science, Springer, vol. 5(4), pages 337-354, October.
    5. Xin Guo & Robert Jarrow & Haizhi Lin, 2008. "Distressed debt prices and recovery rate estimation," Review of Derivatives Research, Springer, vol. 11(3), pages 171-204, October.
    6. Houweling, Patrick & Vorst, Ton, 2005. "Pricing default swaps: Empirical evidence," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1200-1225, December.
    7. Robert Jarrow & Vikrant Tyagi, 2007. "Tax liens: a novel application of asset pricing theory," Review of Derivatives Research, Springer, vol. 10(2), pages 181-204, May.
    8. Roger WALDER, 2002. "Interactions Between Market and Credit Risk: Modeling the Joint Dynamics of Default-Free and Defaultable Bond Term Structures," FAME Research Paper Series rp56, International Center for Financial Asset Management and Engineering.
    9. Maclachlan, Iain C, 2007. "An empirical study of corporate bond pricing with unobserved capital structure dynamics," MPRA Paper 28416, University Library of Munich, Germany.
    10. Jochen R. Andritzky & Manmohan Singh, 2005. "Overpricing in Emerging Market Credit-Default-Swap Contracts; Some Evidence from Recent Distress Cases," IMF Working Papers 05/125, International Monetary Fund.
    11. Xin Guo & Robert A. Jarrow & Yan Zeng, 2009. "Modeling The Recovery Rate In A Reduced Form Model," Mathematical Finance, Wiley Blackwell, vol. 19(1), pages 73-97.
    12. Chen, Ren-Raw & Cheng, Xiaolin & Liu, Bo, 2008. "Estimation and evaluation of the term structure of credit default swaps: An empirical study," Insurance: Mathematics and Economics, Elsevier, vol. 43(3), pages 339-349, December.

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