Recovery Rates, Default Probabilities, and the Credit Cycle

by Max Bruche of the CEMFI, and
Carlos González-Aguado of the CEMFI

March 30, 2009

Abstract: In recessions, the number of defaulting firms rises. On top of this, the average amount recovered on the bonds of defaulting firms tends to decrease. This paper proposes an econometric model in which this joint time-variation in default rates and recovery rate distributions is driven by an unobserved Markov chain, which we interpret as the "credit cycle". This model is shown to fit better than models in which this joint time-variation is driven by observed macroeconomic variables. We use the model to quantitatively assess the importance of allowing for systematic time-variation in recovery rates, which is often ignored in risk management and pricing models.

JEL Classification: G21, G28, G33.

Keywords: Credit, Recovery rate, Default probability, Business cycle, Capital requirements, Markov chain

Published in: Journal of Banking & Finance, Vol. 34, No. 4, (April 2010), pp. 754-764.

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