Discount Rate for Workout Recovery: An Empirical Study

45 Pages Posted: 8 Jun 2006 Last revised: 28 Oct 2007

See all articles by Brooks Brady

Brooks Brady

Standard & Poor's Risk Solutions

Peter Chang

Standard & Poor's - Quantitative Analytics

Peter Miu

McMaster University - DeGroote School of Business

Bogie Ozdemir

Standard & Poor's

David C. Schwartz

Federal Reserve Banks - Federal Reserve Bank of Richmond

Date Written: August 2007

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

Suggested Citation

Brady, Brooks and Chang, Peter and Miu, Peter and Ozdemir, Bogie and Schwartz, David C., Discount Rate for Workout Recovery: An Empirical Study (August 2007). Available at SSRN: https://ssrn.com/abstract=907073 or http://dx.doi.org/10.2139/ssrn.907073

Brooks Brady

Standard & Poor's Risk Solutions ( email )

55 Water Street
New York, NY 10041
United States

Peter Chang

Standard & Poor's - Quantitative Analytics ( email )

55 Water Street
New York, NY 10041
United States

Peter Miu (Contact Author)

McMaster University - DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada
905-525-9140 ext 23981 (Phone)

Bogie Ozdemir

Standard & Poor's ( email )

130 King Street West
Suite 1100, PO Box 486
Toronto, Ontario M5X 1E5
Canada

David C. Schwartz

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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