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| The Economic Role of Jumps and Recovery Rates in the Market for Corporate Default Risk by Paul Schneider of Vienna University of Economics and Business Administration, July 6, 2007 Abstract: Using an extensive cross section of US corporate CDS panels this paper offers an economic understanding of their time-series behavior, implied loss given default, as well as risk premia attached to the risk of sudden jumps in CDS spreads. We take a parametric approach with an affine multi-factor reduced-form model accommodating jumps in both riskless and defaultable factors. Jumps improve the model's capability to capture empirical properties specific to CDS premia. CDS written on obligors in industries with long investment cycles and long-term financing exhibit significantly less frequent jumps. The probability of structural migration to default is considered so low for investment-grade obligors that investors fear distress only through rare, but devastating events. Similarly, investors assign a low probability of structural default to firms with Financials and Utilities sector affiliation. High correlation of default processes with the VIX index indicates a strong relation of corporate CDS premia to equity. Implied LGD is well identified and compares to historically realized values. Obligors with substantial tangible assets are expected to recover more in default. A clear-cut distinction in the level of LGD shows between investment-grade and speculative-grade issuers. Thus, industry practice of assuming equal LGD across ratings and sectors is not compatible with market data. Using our cross section of implied LGD we provide figures which are, on average, consistent with rating and industry. JEL Classification: C11, C15, C51, C52, E43, G13. Keywords: credit default swaps, loss given default, stochastic intensity, jump-diffusion, Markov chain Monte Carlo estimation. Previously titled: Jumps and Recovery Rates Inferred from Corporate CDS Premia Books Referenced in this Paper: (what is this?)
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