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| Recovery Rates, Default Probabilities and the Credit Cycle by Max Bruche of CEMFI, and June 17, 2008 Abstract: In recessions, the number of defaulting firms rises. On top of this, the average amount recovered on the bonds of defaulting firms tends to decrease. This paper proposes an econometric model in which this joint time-variation in default rates and recovery rate distributions is driven by an unobserved Markov chain, which we interpret as the “credit cycle”. This model is shown to fit better than models in which this joint time-variation is driven by observed macroeconomic variables. We use the model to quantitatively assess the importance of allowing for systematic time-variation in recovery rates, which is often ignored in risk management and pricing models. JEL Classification: G21, G28, G33. Keywords: credit, recovery rate, default probability, business cycle, capital requirements, Markov chain. Download paper (329K PDF) 37 pages Related reading: LossCalc v2: Dynamic Prediction of LGD  |  
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