Research on the determinants of historical recovery rates shows that there is a systematic component in recovery risk and that the market practice of assuming constant recovery rates results in a significant underestimation of economic capital (cf. Hu and Perraudin (2002), Altman et al. (2004, 2005) and Rösch and Scheule (2005)). Understanding the dynamics of implied recovery rates is thus of relevance for regulators, risk managers and developers of forward-looking credit risk models.
In this paper, we propose a new approach to estimating market-implied recovery rates from Credit Default Swap (CDS) premia. We exploit the fact that differently-ranking debt instruments of the same issuer face identical default risk but different default-conditional recovery rates. This allows us to overcome a well-known separation problem: In most CDS pricing equations, loss rates and probabilities of default are essentially multiplicatively linked, making a dissection of the two difficult.
Past studies discuss several approaches to mitigating this issue: Zhang (2003), Henrik and Christensen (2005), Karoui (2005), Bakshi et al. (2006) and Pan and Singleton (2008) show that in a reduced-form framework, recovery rates and probabilities of default can be estimated jointly when modeled as functions of a common state variable. Other approaches additionally extract information from multiple asset classes: Jarrow (2001) proposes a model for estimating recovery rates and probabilities of default from debt and equity prices. Janosi et al. (2003) show that the implementation of this model is feasible but find that equity price bubbles can impair the reliability of estimation results. Das and Hanouna (2009) use a binomial tree for estimating the entire term structure of recovery rates and probabilities of default.
Their approach is original in that it requires as input only the current term structure of CDS premia, equity prices and equity volatility and thus evites use of time series data. Unal et al. (2003) estimate recovery rates from debt prices and balance sheet information. They show that, given various types of debt of the same borrower, it is feasible to construct a metric that reflects recovery risk but is void of default risk. Using capital structure data and approximate prices of senior and junior zero coupon bonds, they infer implied firm-wide recovery rates. Their method is appealing insofar as it does not, unlike most others, require an explicit assumption about the process that governs the default intensity and its link to recovery rates.
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Estimating Market-implied Recovery Rates from Credit Default Swap Premia
