Modeling the Recovery Rate in a Reduced Form Model
by Xin Guo of Cornell University & University of California, Berkeley,
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.