Modeling the Recovery Rate in a Reduced Form Model

by Xin Guo of Cornell University & University of California, Berkeley,
Robert A. Jarrow of Cornell University, and
Yan Zeng of Bloomberg L.P.

August 30, 2007

Abstract: This paper provides a model for the recovery rate process in a reduced form model. After default, a firm continues to operate, and the recovery rate is determined by the value of the firm's assets relative to its liabilities. The debt recovers a different magnitude depending upon whether or not the firm enters insolvency and bankruptcy. Although this recovery rate process is similar to that used in a structural model, the reduced form approach is maintained by utilizing information reduction in the sense of Guo, Jarrow and Zeng (2005). Our model is able to provide analytic expressions for a firm's default intensity, bankruptcy intensity, and zero-coupon bond prices both before and after default.

Keywords: credit risk, recovery rates, reduced form model, filtration reduction.

Published in: Mathematical Finance, Vol. 19, No. 1, (January 2009), pp. 73-97.

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