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

45 Pages Posted: 17 Dec 2010 Last revised: 12 Mar 2011

See all articles by Redouane Elkamhi

Redouane Elkamhi

University of Toronto - Rotman School of Management

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Xuhui (Nick) Pan

University of Oklahoma

Date Written: December 8, 2010

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

Suggested Citation

Elkamhi, Redouane and Jacobs, Kris and Pan, Xuhui (Nick), The Cross-Section of Recovery Rates and Default Probabilities Implied by Credit Default Swap Spreads (December 8, 2010). Available at SSRN: https://ssrn.com/abstract=1726126 or http://dx.doi.org/10.2139/ssrn.1726126

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Kris Jacobs (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Xuhui (Nick) Pan

University of Oklahoma ( email )

307 W Brooks
Norman, OK 73019
United States

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