Credit Derivatives: Trading, Investing and Risk Management, Second Edition

2

Default and Recovery Data; Transition Matrices; Historical Pricing

2.1 RECOVERY: ULTIMATE AND MARKET-VALUE-BASED RECOVERY

2.1.1 Ultimate Recovery

In Chapter 1 we discussed recovery in the context of bonds and corporate default. The recovery described was that obtained on the ultimate wind-up of the company and distribution of residual assets. This is referred to as ‘ultimate recovery’.

Ultimate recovery occurs after the default event has taken place, after accountants have been appointed to wind the company up, and after assets have been sold. This process clearly takes a considerable amount of time. Table 2.1 shows the length of time this takes (for US defaults) and how much it varies, while Table 2.2 shows the mean and standard deviation of recovery rates for a range of debt seniorities.

It should be noted that the standard deviation of recovery is very high. Suppose recovery is equally likely to have any value between 0 and 100% (a uniform distribution ⁸). Then the expected recovery level is 50% and the standard deviation turns out to be about 29%. The observed historical average recovery rate actually happens to be very close to that of a uniform distribution, but the standard deviation is even higher. Thus, if we assume that we have a large portfolio of debt, and that 100 of these names default, then on the basis of historical ultimate recoveries we would expect to get a recovery of around 50% on average for the 100 names. However, if we were to pick one of these ...