Structural Rfv: Fundamental Credit Risk Pricing and Hedging with Recovery of Face Value at Default

75 Pages Posted: 24 Jul 2003

See all articles by Rajiv Guha

Rajiv Guha

Alpamayo Capital Management Limited

Alessandro Sbuelz

Catholic University of Milan - Department of Mathematics, Quantitative Finance, and Econometrics; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Date Written: February 25, 2003

Abstract

Receiving the same fractional recovery of par at default for bonds issued by a particular company regardless of maturity has been labelled in the academic literature as a Recovery of Face Value at Default (RFV). Such a recovery form results from language found in typical bond indentures and is supported by empirical evidence from defaulted bond values. We incorporate RFV into a exogenous boundary structural credit risk model and compare the pricing and hedging implications versus other recovery forms more often seen in such models. We find that the recovery form can significantly affect the pricing and sensitivities produced by these models. This has important implications for any practical use of these models as well as for empirical studies attempting to validate structural credit risk models. In general, we provide convincing evidence that choosing the recovery form is not a trivial assumption to make within this class of models. Some of our results complement those found in the literature which examines the endogeneity of the default boundary. We show that some features that may have been solely attributed to modelling the boundary as an optimal decision by the firm can obtain in an exogenous boundary framework which assumes an RFV recovery form. We extend our results to incorporate a multifactor default-free term structure model and examine the impact of the recovery form in estimating the cost of debt capital within a structural model framework.

Suggested Citation

Guha, Rajiv S. and Sbuelz, Alessandro, Structural Rfv: Fundamental Credit Risk Pricing and Hedging with Recovery of Face Value at Default (February 25, 2003). Available at SSRN: https://ssrn.com/abstract=424304 or http://dx.doi.org/10.2139/ssrn.424304

Rajiv S. Guha (Contact Author)

Alpamayo Capital Management Limited ( email )

1 Coldbath Square
London
United Kingdom

Alessandro Sbuelz

Catholic University of Milan - Department of Mathematics, Quantitative Finance, and Econometrics ( email )

largo A. Gemelli 1
I-20123 Milan
Italy
+39 02 7234 2345 (Phone)
+39 02 7234 2671 (Fax)

HOME PAGE: http://ppd.unicatt.it/docenti/alessandro_sbuelz

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Via Sarfatti, 25
Milan, 20136
Italy

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
227
Abstract Views
1,716
Rank
215,094
PlumX Metrics