PROBABILITY DENSITY OF RECOVERY RATE GIVEN DEFAULT OF A FIRM’S DEBT AND ITS CONSTITUENT TRANCHES

Thamayanthi Chellathurai ()
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Thamayanthi Chellathurai: Enterprise Risk and Portfolio Management, BMO Financial Group, 100 King Street West, Toronto, Ontario, Canada M5X 1A1, Canada

International Journal of Theoretical and Applied Finance (IJTAF), 2017, vol. 20, issue 04, 1-34

Abstract: This paper derives the theoretical underpinnings behind the following observed empirical facts in credit risk modeling: The probability of default, the seniority, the thickness of the tranche, the debt cushion, and macroeconomic factors are the important determinants of the conditional probability density function of the recovery rate given default (RGD) of a firm’s debt and its tranches. In a portfolio of debt securities, the conditional probability density functions of the recovery rate given default of tranches have point probability masses near zero and one, and the expected value of the recovery rate given default increases as the seniority or debt cushion increases. The paper derives other results as well, such as the fact that the conditional probability distribution function associated with any senior tranche dominates that of any junior tranche by first-order. The standard deviation of the recovery rate given default of a senior security need not be greater than that of a junior security. It is proved that the expected value of the recovery rate given default need not increase as the proportional thickness of the tranche increases.

Keywords: Recovery rate given default; structured securities; credit risk modeling; mixed random variable; stochastic dominance (search for similar items in EconPapers)
Date: 2017
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DOI: 10.1142/S0219024917500236

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