Default and Recovery Risk Dependencies in a Simple Credit Risk Model

by Benjamin Bade of the University of Hannover,
Daniel Rösch of the University of Hannover, and
Harald Scheule of the University of Melbourne

January 2011

Abstract: This paper provides evidence for the relationship between credit quality, recovery rate, and correlation. The paper finds that rating grade, rating shift, and macroeconomic factors provide a highly significant explanation for default risk and recovery risk of US bond issues. The empirical data suggest that default and recovery processes are highly correlated. Therefore, a joint approach is required for estimating time-varying default probabilities and recovery rates that are conditional on default. This paper develops and applies such a model.

JEL Classification: G20,G28,C51.

Keywords: asset value, correlation, credit portfolio, loss given default, Merton model, probability of default, recovery, volatility

Published in: European Financial Management, Vol. 17, No. 1, (January 2011), pp. 120-144.

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