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The Cross Section of Recovery Rates and Default Probabilities Implied by Credit Default Swap Spreads

Published online by Cambridge University Press:  11 February 2014

Redouane Elkamhi ,
Kris Jacobs  and
Xuhui Pan
Redouane Elkamhi
Affiliation:
redouane.elkamhi@rotman.utoronto.ca, Rotman School of Management, University of Toronto, 105 St. George Street, Toronto, ONT M5S 3E6, Canada
Kris Jacobs
Affiliation:
kjacobs@bauer.uh.edu, Bauer College of Business, University of Houston, 334 Melcher Hall, Houston, TX 77024
Xuhui Pan
Affiliation:
xpan@tulane.edu, Freeman School of Business, Tulane University, 7 McAlister Dr, New Orleans, LA 70118.
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Abstract

Rather than assuming a fixed recovery rate in estimation, we estimate recovery rates from credit default swap spreads, using 3 years of daily data on 152 corporations. We use a quadratic pricing model, which ensures nonnegative default probabilities and recovery rates. The estimated cross section of recovery rates is plausible, with an average recovery rate of 54% and substantial cross-sectional variation. Estimated 5-year default probabilities are on average 67% higher than default probabilities obtained using the standard 40% recovery assumption. This finding critically impacts the valuation of structured credit products. Larger firms and firms with more tangible assets have higher recovery rates.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 49 , Issue 1 , February 2014 , pp. 193 - 220
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2014 

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