The Cross-Section of Recovery Rates and Default Probabilities Implied by Credit Default Swap Spreads

Abstract

Rather than assuming a fixed recovery rate in estimation, we estimate recovery rates from CDS spreads, using three years of daily data on 152 corporates. We use a quadratic pricing model which ensures nonnegative default probabilities and recovery rates. The estimated cross-section of recovery rates is plausible, with an average recovery rate of 54%, and substantial cross-sectional variation. Estimated five-year default probabilities are on average 67% higher than default probabilities obtained using the standard 40% recovery assumption. This finding critically impacts the valuation of structured credit products. Larger firms and firms with more tangible assets have higher recovery rates.

Keywords: CDS, recovery rate, quadratic model, credit risk, default, tangible assets

JEL Classification: G12