The Credit Market Handbook: Advanced Modeling Issues

CHAPTER 3

Survey of the Recent Literature: Recovery Risk

Sanjiv R. Das^a

This chapter surveys selections of recent working papers on recovery rates, providing a framework for extant research. Simpler versions of models are also presented with a view to aid accessibility and pedagogical presentation. Despite the obvious empirical difficulties encountered with recovery rate data, modeling advances are making possible better quantification and measurement of recovery and will result in innovative contracts to span this risk.

1. INTRODUCTION

Default risk has two main components: the risk of default occurrence and the risk of recovery. The extant literature has focused widely on the former, and much too little attention has been given to recovery risk. This is changing, and many working papers on recovery risk have been written recently. This chapter reviews what we know about recoveries and highlights some of the new thinking in this area.

In discrete time, we may write the one-period spread as determined by the probability of default, which we denote as λ, and the loss rate given default (LGD) L = 1 – ϕ, where ϕ is the recovery rate. We restrict ourselves to an exposition in discrete time. Hence, we consider intervals ending at times {t₁,t₂,…,t_N}, where there are N periods and corresponding time points.

More generally, we may think of the credit spread for a given maturity as being a function of a vector of forward probabilities of default and recovery rates, as well as some firm-specific ...