The Link between Default and Recovery Rates: Theory, Empirical Evidence and Implications

27 Pages Posted: 11 Nov 2008

See all articles by Edward I. Altman

Edward I. Altman

New York University (NYU) - Salomon Center; New York University (NYU) - Department of Finance

Brooks Brady

Standard & Poor's Risk Solutions

Andrea Resti

Bocconi University - Department of Finance

Andrea Sironi

Bocconi University - Department of Finance

Multiple version iconThere are 4 versions of this paper

Date Written: March 2003

Abstract

This paper analyzes the association between aggregate default and recovery rates on credit assets, and seeks to empirically explain this critical relationship. We examine recovery rates on corporate bond defaults, over the period 1982-2002. Our econometric univariate and multivariate models explain a significant portion of the variance in bond recovery rates aggregated across all seniority and collateral levels. The central thesis is that aggregate recovery rates are basically a function of supply and demand for the securities, with default rates playing a pivotal role. Such a link would bring about a significant increase in both expected and unexpected losses as measured by some widespread credit risk models, and would affect the procyclicality effects of the New Basel Capital Accord. Our results have also important implications for investors in corporate bonds and bank loans, and for all markets (e.g., securitizations, credit derivatives, etc.) which depend on recovery rates as a key variable.

Keywords: credit rating, capital requirements, credit risk, recovery rate, default, procyclicality

Suggested Citation

Altman, Edward I. and Brady, Brooks and Resti, Andrea and Sironi, Andrea, The Link between Default and Recovery Rates: Theory, Empirical Evidence and Implications (March 2003). NYU Working Paper No. S-FI-03-19. Available at SSRN: https://ssrn.com/abstract=1297797

Edward I. Altman (Contact Author)

New York University (NYU) - Salomon Center ( email )

44 West 4th Street
New York, NY 10012
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212-998-0709 (Phone)
212-995-4220 (Fax)

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Brooks Brady

Standard & Poor's Risk Solutions ( email )

55 Water Street
New York, NY 10041
United States

Andrea Resti

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Andrea Sironi

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

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