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Estimating implied recovery rates from the term structure of CDS spreads

Author

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  • Marcin Jaskowski

    (Erasmus School of Economics, Erasmus University Rotterdam)

  • Michael McAleer

    (Econometric Institute Erasmus School of Economics Erasmus University Rotterdam and Tinbergen Institute The Netherlands and Institute of Economic Research Kyoto University Japan and Department of Quantitative Economics 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.

Suggested Citation

  • Marcin Jaskowski & Michael McAleer, 2012. "Estimating implied recovery rates from the term structure of CDS spreads," KIER Working Papers 836, Kyoto University, Institute of Economic Research.
  • Handle: RePEc:kyo:wpaper:836
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    File URL: http://www.kier.kyoto-u.ac.jp/DP/DP836.pdf
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    References listed on IDEAS

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    1. 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..
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    3. Acharya, Viral V. & Bharath, Sreedhar T. & Srinivasan, Anand, 2007. "Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries," Journal of Financial Economics, Elsevier, vol. 85(3), pages 787-821, September.
    4. 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.
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    6. Das, Sanjiv R. & Hanouna, Paul, 2009. "Implied recovery," Journal of Economic Dynamics and Control, Elsevier, vol. 33(11), pages 1837-1857, November.
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    9. 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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    Cited by:

    1. Foroni, Claudia & Ravazzolo, Francesco & Sadaba, Barbara, 2018. "Assessing the predictive ability of sovereign default risk on exchange rate returns," Journal of International Money and Finance, Elsevier, vol. 81(C), pages 242-264.
    2. repec:wsi:ijtafx:v:20:y:2017:i:04:n:s0219024917500236 is not listed on IDEAS

    More about this item

    Keywords

    Constant recovery; stochastic recovery; implied recovery rate; term structure; CDS spreads.;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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