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Pricing the Risk of Recovery in Default with Absolute Priority Rule Violation

by Haluk Unal of the University of Maryland,
Dilip Madan of the University of Maryland, and
Levent GŁntay of the University of Maryland

August 3, 2001

Abstract: This paper proposes a simple approach to infer the risk-neutral density of recovery rates implied by the prices of the debt securities of a firm. The proposed approach is independent of modeling default arrival rates and allows for the violation of absolute priority rule. The paper demonstrates that a new statistic, the adjusted relative spread, captures risk-neutral recovery information in debt prices. Interest rates and firm tangible assets are shown to be significant determinants of the price of recovery. An application illustrates the pricing of credit derivatives written on the realized recovery rate.

JEL Classification: G13, G33.

Keywords: Recovery rates, Absolute priority rule violation, Risky debt pricing, Credit risk, Credit derivatives.

Published in: Journal of Banking & Finance, Vol. 27, No. 6, (June 2003), pp. 1001-1025.

Previously titled: Pricing the Risk of Recovery in Default with APR Violation --and before that-- A Simple Approach to Estimate Recovery Rates with APR Violation from Debt Spreads

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