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Recovery Rates, Default Probabilities and the Credit Cycle

37 Pages Posted: 30 Nov 2006 Last revised: 6 Jan 2011

Max Bruche

Cass Business School, City University London; Financial Markets Group (LSE)

Carlos González-Aguado

Centre for Monetary and Financial Studies (CEMFI)

Date Written: June 17, 2008

Abstract

In recessions, the number of defaulting firms rises. On top of this, the average amount recovered on the bonds of defaulting firms tends to decrease. This paper proposes an econometric model in which this joint time-variation in default rates and recovery rate distributions is driven by an unobserved Markov chain, which we interpret as the "credit cycle". This model is shown to fit better than models in which this joint time-variation is driven by observed macroeconomic variables. We use the model to quantitatively assess the importance of allowing for systematic time-variation in recovery rates, which is often ignored in risk management and pricing models.

Keywords: credit, recovery rate, default probability, business cycle, capital requirements, Markov chain

JEL Classification: G21, G28, G33

Suggested Citation

Bruche, Max and González-Aguado, Carlos, Recovery Rates, Default Probabilities and the Credit Cycle (June 17, 2008). Journal of Banking and Finance, Vol. 34, No. 4, 2010. Available at SSRN: https://ssrn.com/abstract=934348

Max Bruche (Contact Author)

Cass Business School, City University London ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 (20) 7040 5106 (Phone)
+44 (20) 7040 8881 (Fax)

HOME PAGE: http://www.maxbruche.net

Financial Markets Group (LSE) ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Carlos González-Aguado

Centre for Monetary and Financial Studies (CEMFI) ( email )

Casado del Alisal 5
28014 Madrid
Spain

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