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In Rememberance: World Trade Center (WTC)

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The Dependence of Recovery Rates and Defaults

by Yen-Ting Hu of Birkbeck College, and
William Perraudin of Birkbeck College & Bank of England & CEPR

February 2002

Abstract: In standard ratings-based models for analysing credit portfolios and pricing credit derivatives, it is assumed that defaults and recoveries are statistically independent. This paper presents evidence that aggregate quarterly default rates and recovery rates are, in fact, negatively correlated. Using Extreme Value Theory techniques, we show that the dependence affects the tail behaviour of total credit loss distributions and leads to higher VaR measures.

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