Sovereign Recovery Schemes: Discounting and Risk Management Issues
18 Pages Posted: 5 Nov 2012
Date Written: January 5, 2012
We consider some pricing and risk management issues related to defaultable bonds, in the context of sovereign debt default and restructuring. Standard recovery schemes such as fractional recovery of market value, of Treasury and of face value are investigated: we discuss their consistency with market practice both from a pricing and a risk management perspective. We also pay attention to the tradable basic instruments such as defaultable discount bonds or IOs/POs that are the building blocks of traded level coupon bonds. Model-free pricing formulas are provided. Whatever the recovery framework, bond pricing formulas involve similar ingredients, such as par rates and defaultable level annuities. We also show that the fractional recovery of par, our preferred approach from an economical point of view, involves two discount curves, one for principal payments and one for coupon payments, a departure from the simplest bootstrapping and pricing engines.
Keywords: Defaultable bond pricing, sovereign recovery, discount factor, discount bond
JEL Classification: G01, G12, G33
Suggested Citation: Suggested Citation