Discount Rate for Workout Recovery: An Empirical Study

Abstract

In order to comply with the Advanced Internal Rating-Based (IRB) approach of Basel II, financial institutions need to estimate the economic loss given default (LGD) of their instruments in order to compute the minimum regulatory capital requirement under Pillar I of the accord. One of the key parameters in the estimation of LGD is the appropriate discount rate (and thus risk premium) to be applied to the workout recovery values. By matching the recovery cash flows received post-default with the market prices of defaulted debts, we conduct an empirical analysis to study the determinants of the implicit risk premium by using a comprehensive database comprising both distressed bonds and loans. We find that investor uncertainty concerning the recovery value of defaulted debt is the primary driver of risk premiums. Risk premiums vary significantly by initial issuer ratings, whether or not the industry is in stress at the time of default, relative seniority to other debt and instrument type. The conclusions are found to be robust to potentially confounding determinants of required risk premium.

Keywords: Basel II, Loss Given Default, Recovery Risk, Risk Premium, Discount Rate, Workout Recovery, Defaulted Bonds and Loans

JEL Classification: C13, G21