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The Role of Market-Implied Severity Modeling for Credit VaR

by J. Samuel Baixauli of the University of Murcia, Spain, and
Susana Alvarez of the University of Murcia, Spain

November 2010

Abstract: In this paper a beta-component mixture is proposed to model the market implied severity. Recovery rates are extracted and identified from credit default swaps instead of using defaulted bonds instead using defaulted bonds because it allows us to identify recovery rates of low probability of default companies. An empirical analysis is carried out and the results show that a single beta distribution is rejected as a correct specification for implied severity while a beta-component mixture is accepted. Furthermore, the importance of this modeling approach is highlighted by focusing on its role for credit VaR.

JEL Classification: G13, G20.

Keywords: Implied severity, Credit default swaps, Beta-component mixture, Credit VaR

Published in: Annals of Economics and Finance, Vol. 11, No. 2, (November 2010), pp. 337-353.

Previously titled: Implied Severity Density Estimation: An extended semiparametric approach to compute credit value at risk

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