Time-Dependent Recovery Rates of Defaulted Debt
EEVENT RISK, Marco Avellaneda, ed., Risk Books, Forthcoming
Posted: 2 Nov 2005
We model the conditional probability distribution of trading prices of defaulted large-US-corporate debt given the time since default, the position of the debt on the balance sheet, collateral quality, and economy and industry-wide default rates. The model is based on a maximum expected utility approach. We find that the expected recovery tends to increase (decrease) with the time since default when default occurs in an adverse (good) economic environment. In a middle-of-the-range economic environment, the expected recovery tends to increase with time for a bad (relatively inferior on balance sheet and bad collateral) debt instrument and changes very little with time for a good (relatively superior on balance sheet and good collateral) debt instrument. The conditional variance of the recovery increases with time for a bad debt instrument and is fairly stable to slightly increasing with time for a good debt instrument.
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