Estimating Implied Recovery Rates from the Term Structure of CDS Spreads

Marcin Jaskowski and Michael McAleer
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Marcin Jaskowski: Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam

No 2012-28, Documentos de Trabajo del ICAE from Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico

Abstract: Credit risk models should reflect the observation that the relevant value of collateral is generally not the average value of the asset over all possible states of nature. In most cases, the relevant value of collateral for the lender is its secondary market value in bad states of nature, where marginal utilities are high. Although the negative correlation between recovery rates and default probabilities is well documented, the majority of pricing models does not allow for correlation between the two. In this paper, we propose a relatively parsimonious reduced-form continuous time model that estimates expected recovery rates and default probabilities from the term structure of CDS spreads. The parameters of the model and latent factors driving recovery risk and default risk are estimated using a Bayesian MCMC algorithm. We find that the Bayesian deviance information criterion (DIC) favors the model with stochastic recovery over constant recovery. We also observe that for companies with a good rating, implied constant recovery rates do not difier much from stochastic recovery. However, if a company is very risky, then forward stochastic recovery rates are significantly lower at longer maturities.

Keywords: Constant recovery; Stochastic recovery; Implied recovery rate; Term structure; CDS spreads. (search for similar items in EconPapers)
JEL-codes: E43 G13 G17 G33 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2012-12
New Economics Papers: this item is included in nep-ore
Note: For financial support, the second author wishes to acknowledge the Australian Research Council, National Science Council, Taiwan, and the Japan Society for the Promotion of Science.
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https://eprints.ucm.es/id/eprint/17581/1/1228.pdf (application/pdf)

Related works:
Working Paper: Estimating Implied Recovery Rates from the Term Structure of CDS Spreads (2013)
Working Paper: Estimating implied recovery rates from the term structure of CDS spreads (2012)
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