Structural Recovery of Face Value at Default
by Rajiv Guha of CPIM, London, and
Abstract: A Recovery of Face Value at Default (RFV) means receiving the same fractional recovery of par at default for bonds of the same issuer and seniority, regardless of remaining maturity. We find that RFV in a parsimonious structural credit risk model has a profound impact on hedging interest rate risk as it strongly affects model sensitivities to interest rates. In particular, RFV explains and quantities two important stylized facts: i) the low empirical duration of high-yield bonds and ii) the decreasing sensitivity of credit spreads to interest rates as credit quality declines. The recovery form used in empirical studies influences their interpretation as the default-free term structure (level and slope) interacts with the recovery form in determining model credit spreads.
Keywords: Recovery Forms, Structural Credit Risk Models, Duration.
Previously titled: Structural RFV: Recovery Form and Defaultable Debt Analysis