A New Approach to Estimating Market-Implied Recovery Rates
This chapter illustrates generically how implied recovery rates can be extracted from CDS premia and capital structure information: Section 3.1 first shows that the (observable) ratio of premia of two CDSs referencing the same firm but different types of debt of this firm is a function only of respective implied expected recovery rates but not of the implied probability of default. Section 3.2 then illustrates how this ratio can be expressed as a function of capital structure information if a functional form for the implied probability distribution of recovery is supposed. Section 3.3 discusses sensible characteristics of the latter and chooses a beta distribution for the further proceeding.
KeywordsRecovery Rate Beta Distribution Capital Structure Debt Holder Zero Coupon Bond
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