Dependence of Defaults and Recoveries in Structural Credit Risk Models

by Rudi Schäfer of the University of Duisburg-Essen, and
Alexander F.R. Koivusalo of Danske Capital

March 30, 2011

Abstract: The current research on credit risk is primarily focused on modeling default probabilities. Recovery rates are often treated as an afterthought; they are modeled independently, in many cases they are even assumed constant. This is despite of their pronounced effect on the tail of the loss distribution. Here, we take a step back, historically, and start again from the Merton model, where defaults and recoveries are both determined by an underlying process. Hence, they are intrinsically connected. For the diffusion process, we can derive the functional relation between expected recovery rate and default probability. This relation depends on a single parameter only. In Monte Carlo simulations we find that the same functional dependence also holds for jump-diffusion and GARCH processes. We discuss how to incorporate this structural recovery rate into reduced-form models, in order to restore essential structural information which is usually neglected in the reduced-form approach.

JEL Classification: C15, G21, G24, G28, G33.

Keywords: Credit risk, Loss distribution, Value at Risk, Expected Tail Loss, Stochastic processes.

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