Credit Spreads, Recovery Rates and Bond Portfolio Risk Measures in a Hybrid Credit Risk Model

39 Pages Posted: 17 Aug 2012 Last revised: 8 Dec 2012

See all articles by Geneviève Gauthier

Geneviève Gauthier

HEC Montreal - Department of Decision Sciences; HEC Montreal - Department of Management Sciences

Mathieu Boudreault

University of Quebec at Montreal (UQAM)

Tommy Thomassin

HEC Montreal

Date Written: August 16, 2012

Abstract

This paper presents a framework in which many structural credit risk models can be made hybrid by randomizing the default trigger, while keeping the capital structure intact. This produces random recovery rates negatively correlated with the default probability. The approach is implemented on a firm-by-firm basis using maximum likelihood and the unscented Kalman filter (UKF) on each of the 225 companies of the CDX NA IG and HY indices using weekly CDS data from December 2007 to January 2012. Adding the surprise element and the time-varying distribution of recovery rates has a large impact on credit spreads as it modifies both the level and shape of the curves. When a bond portfolio is considered, the presence of dependence among firm leverage ratios and between default probabilities and recovery rates produces clusters of defaults with low recovery rates. It has a major impact on standard risk measures such as Value- at-Risk and conditional tail expectation.

Keywords: Credit risk, recovery rate, CDS, hybrid model, intensity, VaR

JEL Classification: G33, C32

Suggested Citation

Gauthier, Genevieve and Boudreault, Mathieu and Thomassin, Tommy, Credit Spreads, Recovery Rates and Bond Portfolio Risk Measures in a Hybrid Credit Risk Model (August 16, 2012). Available at SSRN: https://ssrn.com/abstract=2130851 or http://dx.doi.org/10.2139/ssrn.2130851

Genevieve Gauthier (Contact Author)

HEC Montreal - Department of Decision Sciences ( email )

3000 Côte-Sainte-Catherine Road
Montreal, QC H2S1L4
Canada

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada

Mathieu Boudreault

University of Quebec at Montreal (UQAM) ( email )

PB 8888 Station DownTown
Succursale Centre Ville
Montreal, Quebec H3C3P8
Canada

Tommy Thomassin

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3
Canada

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