Analyzing and Explaining Default Recovery Rates
Abstract: This comprehensive report analyzes the impact of various assumptions about the association between aggregate default probabilities and the loss given default on bank loans and corporate bonds, and seeks to empirically explain this critical relationship. The analysis has important implications for the results of various value-at-risk credit risk models as well as the fundamental factors which influence fixed income portfolio models and strategies. Virtually all of the literature on credit risk management models and tools treat the important recovery rate variable as a function of historic average default recovery rates, conditioned perhaps on seniority and collateral factors, and in almost all cases as independent of expected or actual default rates. This report examines that assumption in the extant literature, in value-at-risk simulations based on several critical assumptions on the correlation between default and recovery rates, and in actual empirical tests. We specify and empirically test for a negative relationship between these two key inputs to credit loss estimates, and find that the result is indeed significantly negative with profound effects on value-at-risk and other measures.