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Discount Rate for Workout Recoveries: An empirical study

by Brooks Brady of American Express,
Peter Chang of Standard & Poor's,
Peter Miu of McMaster University,
Bogie Ozdemir of Standard & Poor's, and
David Schwartz of the Federal Reserve Bank of Richmond

September 2006

Abstract: Banks must measure the loss arising from counterparty default in order to achieve Advanced Internal Ratings-Based (IRB) compliance under the proposed Basel II minimum regulatory capital framework. The discount rate to be used on cash received post-default is not agreed upon amongst practitioners and banking supervisors. We review alternative extant proposals and develop a framework for choosing an appropriate discount rate contingent upon the risk of the recovery cash flow. Empirical results are presented by using a comprehensive database of trading prices and workout recoveries of both distressed bonds and loans. We find that discount rates vary significantly by initial issuer ratings, whether or not the industry is in stress at the time of default, relative seniority to other debt and instrument type. The conclusions are found to be robust to potentially confounding determinants of discount rate.

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Related reading: Choosing the Discount Factor for Estimating Economic LGD,
The Risk-Adjusted Cost of Financial Distress