A Multifactor Approach for Systematic Default and Recovery Risk

by Daniel Rösch of the University of Regensburg, and
Harald Scheule of the University of Melbourne

September 2005

Abstract: The following article develops a simultaneous multi-factor model for defaults and recoveries. Applying this model, risk parameters can be forecast using systematic and idiosyncratic risk factors and their implied correlations. The theoretical framework is accompanied by an empirical analysis in which a negative correlation between defaults and recoveries over the business cycle is observed. In the study, default and recovery rates are modeled by business cycle indicators and the properties of the economic and regulatory capital given these risk drivers are shown.

JEL Classification: G20, G28, C51.

Keywords: Recoveries, Loss Given Default, Correlations, Basel II.

Published in: Journal of Fixed Income, Vol. 15, No. 2, (September 2005), pp. 63-75.

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