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In Rememberance: World Trade Center (WTC)

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Distressed Debt Prices and Recovery Rate Estimation

by Xin Guo of the University of California, Berkeley,
Robert A. Jarrow of the Cornell University & Kamakura Corp., and
Haizhi Lin of the Cornell University

January 26, 2009

Abstract: This paper has two purposes. First, it uses distressed debt prices to estimate recovery rates at default. In this regard, estimates are obtained for three recovery rate models: recovery of face value, recovery of Treasury, and recovery of market value. We show that identifying the "economic" default date, as distinct from the recorded default date, is crucial to obtaining unbiased estimates. The economic default date is defined to be the first date when the market prices the firm's debt as if it has defaulted. An implication is that the standard industry practice of using 30-day post default prices to compute recovery rate yields biased estimates. Second, we construct and estimate a distressed debt pricing model. We use this model to implicitly estimate the parameters of the embedded recovery rate process and to price distressed debt. Our distressed debt pricing model fits market prices well, with an average pricing error of less than one basis point.

JEL Classification: G13, G33, G34.

Keywords: Recovery rates, Distressed debt, Credit risk, Default time, Bankruptcy time

Published in: Review of Derivatives Research, Vol. 11, No. 3, (October 2008), pp. 171-204.

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