Given the current economic crisis, accentuated by the incorrect assessment of the default risk imbedded in subprime mortgages, the study of credit risk has assumed increased importance to the financial industry and regulators. In the existing literature, significant emphasis has been devoted to understanding the default process (the default probability) for a collection of credit risk entities.
Less emphasis, however, has been placed on understanding the recovery rate process itself. Understanding the recovery rate process is, of course, of equal importance to understanding the default likelihood in the valuation and hedging of risky debt and credit derivatives. Our paper adds to the literature on the recovery rate process.
The existing empirical literature studying recovery rates can be divided into various groups. The first group are industry papers that provide estimates of recovery rates and characterize their properties (see Moodyps [20], [21], [22]). Unfortunately, although these papers provide estimates of recovery rates, they do not provide details on the estimation procedure nor do they provide a com' parison of alternative estimation methods.
The second group are a collection of academic papers that use these industry generated recovery rates (usually from Moodyps Investor Services) to study the behavior of the recovery rates at default (see Altman, Brady, Resti and Sironi [3], Altman, Resti and Sironi [4], Acharya, Bharath, and Srinivasan [1], Covitz and Han [9], Chava, Stefanescu and Turnbull [8]). These papers provide some useful insights, but they are predicated on the validity of the industry recovery rate estimates. If the industry recovery rates are biased or misspecified, then these results can not be accepted as valid.
Lastly, there are a few papers that use pre'default risky debt or credit default swap (CDS) pricing models to infer the embedded recovery rate (see Bakshi, Madan, Zhang [5], Janosi, Jarrow and Yildirim [14], and Das and Hanouna [10]). These papers are not dependent on the validity of the industry recovery rate estimates. However, without the historical recovery rate estimates, there is no way to independently determine whether the implicit estimates are reasonable. For a review of the literature on recovery rates see Schuermann [24].
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