Modeling and Estimating Recovery Rates

Conceptually, three main variables affect the credit risk of a financial asset: the probability of default (PD); the “loss given default”, which is equal to one minus the recovery rate (RR) in the event of default; and the exposure at default. The RR, usually defined as the market price of the security just after default, is one of the two key variables analyzed by market practitioners in the pricing and other variables in the hugely important credit market. This chapter presents a detailed review of the way credit risk models, developed during the past 40 years, have treated the recovery rate and, more specifically, its relationship with the probability of default of an obligor. It reviews the recent studies that explicitly model and empirically investigate the relationship between PD and RR. The chapter also presents some recent empirical evidence on recovery rates on both defaulted bonds and loans.