Structural Rfv: Fundamental Credit Risk Pricing and Hedging with Recovery of Face Value at Default
75 Pages Posted: 24 Jul 2003
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.
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