Implied Recovery

37 Pages Posted: 11 Nov 2007 Last revised: 25 Sep 2015

See all articles by Sanjiv Ranjan Das

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business

Paul Hanouna

Villanova University - School of Business

Date Written: November 1, 2008

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 exible jump-to-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 identication 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 exible, 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.

Keywords: Implied, Recovery, Loss-Given-Default, Credit Default Swaps

JEL Classification: G0, G1

Suggested Citation

Das, Sanjiv Ranjan and Hanouna, Paul E., Implied Recovery (November 1, 2008). Journal of Economic Dynamics and Control, Vol. 33, No. 11, 2009. Available at SSRN: https://ssrn.com/abstract=1028612 or http://dx.doi.org/10.2139/ssrn.1028612

Sanjiv Ranjan Das (Contact Author)

Santa Clara University - Leavey School of Business ( email )

Department of Finance
316M Lucas Hall
Santa Clara, CA 95053
United States

HOME PAGE: http://algo.scu.edu/~sanjivdas/

Paul E. Hanouna

Villanova University - School of Business ( email )

800 Lancaster Avenue
Villanova, PA 19085-1678
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
557
rank
45,289
Abstract Views
2,144
PlumX Metrics