Implied Recovery

Abstract

In the absence of forward-looking models for recovery rates, market participants tend to use exogenously assumed constant recovery rates in pricing models. We develop a flexible jumpto-default model that uses observables: the stock price and stock volatility in conjunction with credit spreads to identify implied, endogenous, dynamic functions of the recovery rate and default probability. The model in this paper is parsimonious and requires the calibration of only three parameters, enabling the identification of the risk-neutral term structures of forward default probabilities and recovery rates. Empirical application of the model shows that it is consistent with stylized features of recovery rates in the literature. The model is flexible, i.e., it may be used with different state variables, alternate recovery functional forms, and calibrated to multiple debt tranches of the same issuer. The model is robust, i.e., evidences parameter stability over time, is stable to changes in inputs, and provides similar recovery term structures for different functional specifications. Given that the model is easy to understand and calibrate, it may be used to further the development of credit derivatives indexed to recovery rates, such as recovery swaps and digital default swaps, as well as provide recovery rate inputs for the implementation of Basel II.

Pricing CDOs with state-dependent stochastic recovery rates

“…Thus the relevant quantity for predicting a default payout is the recovery rate conditional on a tranche being hit, and not simply the individual names' expected recovery as used by vanilla credit default swap traders to convert a running spread to an upfront value and vice versa. Actually, Das and Hanouna [2008] show negative correlation between recovery rates and default probabilities in the risk-neutral world. This feature is included in the models studied by Amraoui Prampolini and Dinnis [2009].…”

Implied Recovery Rates—Auctions and Models

“…The identification problem among long-term default probabilities and recovery rates is not limited to the presented CIR model, but can also be observed, e.g., in jump-to-default equity models such as the one proposed in Das and Hanouna [13]. We illustrated one way to circumvent the problem by reducing the calibrated expression to a form, where only recoveryrelated parameters appear.…”

“…A default in a period of high expected distress, e.g., in an economic downturn, entails lower recoveries The spreads represent two whole term structures, which are used to calibrate the presented implied recovery approaches in every displayed week independently and vice versa. Comparable choices for modeling recoveries can be found, e.g., in Madan et al [12], Das and Hanouna [13], Höcht and Zagst [14], or Jaskowski and McAleer [11]. Since the model will be calibrated to one CDS spread curve, one has to be restrictive concerning the amount of free model parameters in the recovery model.…”

Distressed debt prices and recovery rate estimation

“…Similar to Bakshi, Madan, Zhang [5], Janosi, Jarrow and Yildirim [14], and Das and Hanouna [10]) we formulate and estimate a new recovery rate process useful for pricing distressed debt. Our model is shown to provide a good …t to the market prices of distressed debt.…”

“…If the industry recovery rates are biased or misspeci…ed, 1 then these results can not be accepted as valid. Lastly, there are a few papers that use pre-default risky debt or credit default swap (CDS) pricing models to infer the embedded recovery rate (see Bakshi, Madan, Zhang [5], Janosi, Jarrow and Yildirim [14], and Das and Hanouna [10]). These papers are not dependent on the validity of the industry recovery rate estimates.…”