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| Implied Recovery by Sanjiv R. Das of Santa Clara University, and March 2007 Abstract: The extraction of recovery rates from credit-sensitive securities is an important open problem in the default risk area. Further, the determinants of recovery levels on default are also little understood. We develop a technique for bootstrapping implied risk-neutral forward recovery rate term structures from credit default swap (CDS) spread curves at any single point in time, using only the cross-section of spreads and an additional identification condition. The model accommodates different possible functional relationships between default and recovery to enable simultaneous identification of both hazard rate and recovery term structures under the risk-neutral measure; the underlying fixed-point algorithm is fast and convergent. No time series data is required. We then use indicative CDS spread data from 3,130 firms from January 2000 to July 2002, and extract recovery rates for each firm; these exhibit a strong negative correlation with default probabilities. A principal components analysis of the recovery rates finds one major component (the level of the risk free rate) and another minor one (implied volatility of S&P 500). Market variables are able to explain the variation in the first and second components very well, with R2s of 90.8% and 35.5% respectively, suggesting that the recovery rate may be modeled on observable factors for trading purposes. Books Referenced in this Paper: (what is this?)
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