Options-based Structural Model Estimation of Bond Recovery Rates
by Robert R. Cangemi, Jr. of Citigroup,
September 4, 2007
Abstract: The present paper hypothesizes that a real options characterization of an optimal stopping problem can explain a large amount of the variability in losses on defaulted corporate debt securities. Further augmenting this approach by modeling a system of equations that jointly estimates the market values of debt and equity adds considerable explanatory power. Empirical tests with a large number of corporate defaults confirm the usefulness of the approach. Moreover, higher volatility and lower discount rates around business cycle turning points can result in stakeholders waiting longer for additional returns from defaulted debt. Such optimal stopping behavior mitigates the debt "haircut" (the reduction in face value of debt and/or increase in stated maturity that resolves the default) but prolongs the duration of financial distress. Hence, the real options approach creates an intuitive and powerful framework for analyzing debt values across the business cycle.
Forthcoming in: Journal of Financial Intermediation.
Previously titled: How Much of a Haircut? Options-based structural modeling of defaulted bond recovery rates