Implied Recovery

by Sanjiv R. Das of Santa Clara University, and
Paul Hanouna of Villanova University

May 2, 2009

Abstract: In the absence of forward-looking models for recovery rates, market participants tend to use exogenously assumed constant recovery rates in pricing models. We develop a flexible jump-to-default model that uses observables: the stock price and stock volatility in conjunction with credit spreads to identify implied, endogenous, dynamic functions of the recovery rate and default probability. The model in this paper is parsimonious and requires the calibration of only three parameters, enabling the identification of the risk-neutral term structures of forward default probabilities and recovery rates. Empirical application of the model shows that it is consistent with stylized features of recovery rates in the literature. The model is flexible, i.e., it may be used with different state variables, alternate recovery functional forms, and calibrated to multiple debt tranches of the same issuer. The model is robust, i.e., evidences parameter stability over time, is stable to changes in inputs, and provides similar recovery term structures for different functional specifications. Given that the model is easy to understand and calibrate, it may be used to further the development of credit derivatives indexed to recovery rates, such as recovery swaps and digital default swaps, as well as provide recovery rate inputs for the implementation of Basel II.

JEL Classification: G12.

Published in: Journal of Economic Dynamics and Control, Vol. 33, No. 11, (November 2009), pp. 1837-1857.

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