Showing papers on "Credit risk published in 2003"

Credit Risk : Pricing, Measurement, and Management

Abstract: In this book, two of America's leading economists provide the first integrated treatment of the conceptual, practical, and empirical foundations for credit risk pricing and risk measurement. Masterfully applying theory to practice, Darrell Duffie and Kenneth Singleton model credit risk for the purpose of measuring portfolio risk and pricing defaultable bonds, credit derivatives, and other securities exposed to credit risk. The methodological rigor, scope, and sophistication of their state-of-the-art account is unparalleled, and its singularly in-depth treatment of pricing and credit derivatives further illuminates a problem that has drawn much attention in an era when financial institutions the world over are revising their credit management strategies. Duffie and Singleton offer critical assessments of alternative approaches to credit-risk modeling, while highlighting the strengths and weaknesses of current practice. Their approach blends in-depth discussions of the conceptual foundations of modeling with extensive analyses of the empirical properties of such credit-related time series as default probabilities, recoveries, ratings transitions, and yield spreads. Both the "structura" and "reduced-form" approaches to pricing defaultable securities are presented, and their comparative fits to historical data are assessed. The authors also provide a comprehensive treatment of the pricing of credit derivatives, including credit swaps, collateralized debt obligations, credit guarantees, lines of credit, and spread options. Not least, they describe certain enhancements to current pricing and management practices that, they argue, will better position financial institutions for future changes in the financial markets. Credit Risk is an indispensable resource for risk managers, traders or regulators dealing with financial products with a significant credit risk component, as well as for academic researchers and students.

Enterprise Risk Management: From Incentives to Controls

Abstract: Preface. Acknowledgments. SECTION I. RISK MANAGEMENT IN CONTEXT. Chapter 1. Introduction. Chapter 2. Lessons Learned. Chapter 3. Concepts and Processes. SECTION II. THE ENTERPRISE RISK MANAGEMENT FRAMEWORK. Chapter 4. What Is Enterprise Risk Management? Chapter 5. Corporate Governance. Chapter 6. Line Management. Chapter 7. Portfolio Management. Chapter 8. Risk Transfer. Chapter 9. Risk Analytics. Chapter 10. Data and Technology. Chapter 11. Stakeholder Management. SECTION III. RISK MANAGEMENT APPLICATIONS. Chapter 12. Credit Risk Management. Chapter 13. Market Risk Management. Chapter 14. Operational Risk Management. Chapter 15. Business Applications. Chapter 16. Financial Institutions. Chapter 17. Energy Firms. Chapter 18. Nonfinancial Corporations. SECTION IV. A LOOK TO THE FUTURE. Chapter 19. Predictions. Chapter 20. Everlast Financial. Index.

Are Credit Ratings Procyclical

Abstract: This paper studies the influence of the state of the business cycle on credit ratings. In particular, we assess whether rating agencies are excessively procyclical in their assignment of ratings. Our analysis is based on a model of ratings determination that takes into account factors that measure the business and financial risks of firms, in addition to indicators of macroeconomic conditions. Utilizing annual data on all US firms rated by Standard & Poor's, we find little evidence of procyclicality in ratings. By contrast, we find that initial ratings and rating changes exhibit excess sensitivity to the business cycle. The paper offers two explanations of these results.

Credit Derivatives Pricing Models

Abstract: The credit derivatives market is booming and, for the first time, expanding into the banking sector which previously has had very little exposure to quantitative modeling. This phenomenon has forced a large number of professionals to confront this issue for the first time. Credit Derivatives Pricing Models provides an extremely comprehensive overview of the most current areas in credit risk modeling as applied to the pricing of credit derivatives. As one of the first books to uniquely focus on pricing, this title is also an excellent complement to other books on the application of credit derivatives. Based on proven techniques that have been tested time and again, this comprehensive resource provides readers with the knowledge and guidance to effectively use credit derivatives pricing models. Filled with relevant examples that are applied to real-world pricing problems, Credit Derivatives Pricing Models paves a clear path for a better understanding of this complex issue.

Credit Constraints in Manufacturing Enterprises in Africa

Abstract: We investigate the question whether firms in the manufacturing sector in Africa are credit constrained. The fact that few firms obtain credit is not sufficient to prove constraints, since certain firms may not have a demand for credit while others may be refused credit as part of profit maximising behaviour by banks. To investigate this question, we use direct evidence on whether firms had a demand of credit and whether their demand was satisfied in the formal credit market, based on panel data on firms in the manufacturing sector from six African countries. More than half the firms in the sample had no demand for credit. Of those firms with a demand for credit, only a quarter obtained a formal sector loan. In line with expectations, our analysis suggests that banks allocate credit on the basis of expected profits. However, controlling for credit demand, outstanding debt is positively related with obtaining further lending while micro or small firms are less likely to get a loan than large firms. The latter effect is strong and present in the regression, despite including several variables typically referred to as explaining why small or ‘informal’ firms do not get credit. The role of outstanding debt is likely to be a reflection of inefficiency in credit markets, while the fact that size matters is consistent with a bias as well, although we cannot totally exclude that they reflect transactions costs on the part of banks. Finally, we could not detect any differences between countries in the effects of these factors in the credit allocation rule, although financial deepening is found to explain most of the country-specific fixed effects, shifting the probability of obtaining credit across the firm distribution.

Quantifying Credit Risk I: Default Prediction

Abstract: Until the 1990s, corporate credit analysis was viewed as an art rather than a science because analysts lacked a way to adequately quantify absolute levels of default risk. In the past decade, however, a revolution in credit-risk measurement has taken place. The evidence from this research presents a compelling case that the conceptual approach pioneered by Fischer Black, Robert Merton, and Myron Scholes provides a powerful practical basis for measuring credit risk. “Quantifying Credit Risk II: Debt Valuation” shows that their approach provides superior explanations of secondary-market debt prices.

Financial Risk Manager Handbook

Abstract: Handbook presents the various disciplines associated with financial risk management. Text was first created as a study support manual for the GARP's annual FRM exam, and as a general guide to assessing and controlling financial risk in today's rapidly changing environment. This edition is expanded to be suitable as a reference text for any risk professional. Back Cover Copy A comprehensive reference and training guide for financial risk management. Risk professionals looking to earn the Financial Risk Manager (FRM) certification, corporate training programs, professors, and graduate students all rely on one book for the most comprehensive and up-to-date information on financial risk management the Financial Risk Manager Handbook. Presented in a clear and consistent fashion, this completely updated Second Edition is the best way to prepare for the Financial Risk Manager (FRM) exam and has become the core text for risk management training programs worldwide. This definitive guide supports candidates studying for GARP?s annual FRM exam and prepares you to assess and control risk in today?s rapidly changing financial world. Financial Risk Manager Handbook, Second Edition summarizes the core body of knowledge for financial risk managers, covering such topics as quantitative methods, capital markets, as well as credit, operational, market, and integrated risk management. It also discusses relevant regulatory, legal, and accounting issues essential to risk professionals. The FRM is recognized as the world?s most prestigious global certification program created to measure a financial risk manager?s capabilities. With the FRM exam fast becoming an essential requirement for risk managers around the world, the Financial Risk Manager Handbook, Second Edition focuses on practical financial risk management techniques and solutions that are emphasized on the test and essential in the real world. Questions from previous exams are explained through tutorials so that you may prepare yourself or your employees for this comprehensive exam and for the risk management scenarios you will face at some point in your career. Table of Contents: Part I. Quantitative Analysis (Ch 1-4) Part II. Capital Markets (Ch 5-10) Part III. Market Risk Management (Ch 11-17) Part IV. Credit Risk Management (Ch 18-23) Part V. Operational and Integrated Risk Management (Ch 24-27) Part VI. Legal,Accounting and Tax Risk Management (Ch 28-29) Part VII. regulation and Compliance (Ch 30-32) About the Author PHILIPPE JORION is Professor of Finance at the Graduate School of Management at the University of California at Irvine. He holds an MBA and a PhD from the University of Chicago and a degree in engineering from the University of Brussels. Dr. Jorion has authored more than seventy publications directed towards academics and practitioners on the topic of risk management and international finance. He is Editor of the Journal of Risk and is on the editorial board of a number of other financial journals. He has won the Smith Breeden Prize for research and the William F. Sharpe Award for Scholarship in Financial Research. He has written the first edition of Financial Risk Manager Handbook as well as Financial Risk Management: Domestic and International Dimensions, Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County, and Value at Risk: The New Benchmark for Managing Financial Risk.

The High Demand for International Reserves in the Far East: What's Going On?

Abstract: This paper explores econometric and theoretical interpretations for the relatively high demand for international reserves by countries in the Far East and the relatively low demand by some other developing countries. Using a sample of about 125 developing countries, we show that reserve holdings over the 1980-1996 period seem to be the predictable outcome of a few key factors, such as the size of international transactions, their volatility, the exchange-rate arrangement, and political considerations. The estimating equation also does a good job of predicting reserve holdings in Asia before the 1997 financial crisis. After the crisis, the estimating equation significantly under-predicts the reserve holdings of several key Far East countries, as one might expect from the Lucas Critique. This under-prediction is consistent with models explaining the demand for international reserves by developing countries. Specifically, we show that sovereign risk and costly tax collection to cover fiscal liabilities lead to a relatively large demand for international reserves. In the aftermath of a crisis, countries that have to deal with higher perceived sovereign risk and higher fiscal liabilities (both funded and unfunded) will opt to increase their demand for reserves. The models also help us understand why some developing countries do not hold large precautionary reserve balances in the aftermath of crises. Countries with high discount rates, political instability or political corruption find it optimal to hold much smaller precautionary balances. We also show that models that incorporate loss aversion predict a relatively large demand for international reserves. Hence, if a crisis increases the volatility of shocks and/or loss aversion, it will greatly increase in the demand for international reserves. Consequently, we conclude that the ‘puzzling’ pattern in international reserve holdings is reasonably explained by the extended models described in this paper.

Common poisson shock models: applications to insurance and credit risk modelling

Abstract: The idea of using common Poisson shock processes to model dependent event frequencies is well known in the reliability literature. In this paper we examine these models in the context of insurance loss modelling and credit risk modelling. To do this we set up a very general common shock framework for losses of a number of different types that allows for both dependence in loss frequencies across types and dependence in loss severities. Our aims are threefold: to demonstrate that the common shock model is a very natural way of approaching the modelling of dependent losses in an insurance or risk management context; to provide a summary of some analytical results concerning the nature of the dependence implied by the common shock specification; to examine the aggregate loss distribution that results from the model and its sensitivity to the specification of the model parameters.

Credit reporting and financing constraints

Abstract: The authors combine firm-level data from the World Bank Business Environment Survey (WBES) with data on private and public credit registries to investigate whether the presence of a credit registry in a country is associated with lower financing constraints, as perceived by managers, and with higher share of bank financing. They find that the existence of private credit registries is associated with lower financing constraints and higher share of bank financing, while the existence of public credit registries does not seem to have a significant effect on these perceived financing constraints. The authors also find that small- and medium-sized firms tend to have a higher share of bank financing in countries where private registries exist and stronger rule of law is associated with more effective private credit registries. Finally, the authors find some evidence that the presence of a public credit registry benefits younger firms relatively more than older firms.

Default Recovery Rates in Credit Risk Modeling: A Review of the Literature and Empirical Evidence

Abstract: Evidence from many countries in recent years suggests that collateral values and recovery rates on corporate defaults can be volatile and, moreover, that they tend to go down just when the number of defaults goes up in economic downturns. This link between recovery rates and default rates has traditionally been neglected by credit risk models, as most of them focused on default risk and adopted static loss assumptions, treating the recovery rate either as a constant parameter or as a stochastic variable independent from the probability of default. This traditional focus on default analysis has been partly reversed by the recent significant increase in the number of studies dedicated to the subject of recovery rate estimation and the relationship between default and recovery rates. This paper presents a detailed review of the way credit risk models, developed during the last thirty years, treat the recovery rate and, more specifically, its relationship with the probability of default of an obligor. Recent empirical evidence concerning this issue is also presented and discussed.

The credit spread puzzle

Abstract: Spreads on corporate bonds tend to be many times wider than what would be implied by expected default losses alone. These spreads are the difference between yields on corporate debt subject to default risk and government bonds free of such risk.2 While credit spreads are often generally understood as the compensation for credit risk, it has been difficult to explain the precise relationship between spreads and such risk. In 1997–2003, for example, the average spread on BBB-rated corporate bonds with three to five years to maturity was about 170 basis points at annual rates. Yet, during the same period, the average yearly loss from default amounted to only 20 basis points.In this case, the spread was more than eight times the expected loss from default. The wide gap between spreads and expected default losses is what we call the credit spread puzzle. In this article we argue that the answer to the credit spread puzzle might lie in the difficulty of diversifying default risk. Most studies to date have implicitly assumed that investors can diversify away the unexpected losses in a corporate bond portfolio. However, the nature of default risk is such that the distribution of returns on corporate bonds is highly negatively skewed. Such skewness would require an extraordinarily large portfolio to achieve full diversification. Evidence from the market for collateralised debt obligations (CDOs) indicates that in practice such large portfolios are unattainable, and thus unexpected losses are unavoidable. Hence, we argue that spreads are so wide because they are pricing undiversified credit risk. We first review the existing evidence on the determinants of credit spreads, including the role of taxes, risk premia and liquidity premia. We then discuss the role of unexpected losses and the difficulties involved in diversifying credit portfolios, drawing on evidence from the CDO market.

Credit reporting systems and the international economy

Abstract: Credit reporting is a critical part of the financial system in most developed economies but is often weak or absent in developing countries. It addresses a fundamental problem of credit markets: asymmetric information between borrowers and lenders that can lead to adverse selection and moral hazard. The heart of a credit report is the record it provides of an individual's or a firm's payment history, which enables lenders to evaluate credit risk more accurately and lower loan processing time and costs. Credit reports also strengthen borrower discipline, since nonpayment with one institution results in sanctions with others.This book provides the first comprehensive review of credit reporting systems worldwide and documents the rapid growth in the industry. It offers empirical and theoretical evidence of the impact of credit reporting on financial markets, using examples from both developed and developing economies. Credit reporting, it shows, significantly contributes to predicting default risk of potential borrowers, which promotes increased lending activity. The book also covers the role of public policy in the development of credit reporting initiatives, including the role of public credit registries managed by central banks; and the role of legal, regulatory, and institutional factors in supporting credit reporting.

Empirical Determinants of Emerging Market Economies' Sovereign Bond Spreads

Abstract: This paper investigates the empirical determinants of emerging market sovereign bond spreads, using a ragged-edge panel of JP Morgan EMBI and EMBI Global secondary market spreads and a set of common macro-prudential indicators. The panel is estimated using the pooled mean group technique due to Pesaran, Shin and Smith (1999). This is essentially a dynamic error correction model where cross-sectional coefficients are allowed to vary in the short run but are required to be homogeneous in the long run. This allows a separation of short-run dynamics and adjustment towards the equilibrium. The model is used to benchmark market spreads and assess whether sovereign risk was 'overpriced' or 'underpriced' during different periods over the past decade. The results suggest that a debtor country's fundamentals and external liquidity conditions are important determinants of market spreads. However, the diagnostic statistics also indicate that the market assessment of a country's creditworthiness is more broad based than that provided by the set of fundamentals included in the model. We also find that the generalised fall in sovereign spreads seen between 1995 and 1997 cannot be entirely explained in terms of improved fundamentals.

Are unsolicited credit ratings biased downward

Abstract: There has been considerable controversy over unsolicited credit ratings in recent years. Some dissatisfied issuers allege that unsolicited ratings are biased downward in contrast to solicited ratings. This is the first empirical study to analyze the controversy using pooled time-series cross-sectional data of 265 firms in 15 countries from Standard and Poor’s Ratings Services (S&P’s) during the period of 1998–2000. The results demonstrate that unsolicited ratings are lower. On the other hand, I also find that those issuers who choose not to obtain rating services from S&P’s have weaker financial profiles. Although the difference in ratings can be explained by this significant self-selection bias, results of the Japanese sub-sample indicate that unsolicited ratings are still lower than solicited ratings after controlling for differences in sovereign risk and key financial characteristics.

How Much of Corporate-Treasury Yield Spread Is Due to Credit Risk?: A New Calibration Approach

Abstract: No consensus has yet emerged from the existing credit risk literature on how much of the observed corporate-Treasury yield spreads can be explained by credit risk. In this paper, we propose a new calibration approach based on historical default data and show that one can indeed obtain consistent estimate of the credit spread across many different economic considerations within the structural framework of credit risk valuation. We find that credit risk accounts for only a small fraction of the observed corporate-Treasury yield spreads for investment grade bonds of all maturities, with the fraction smaller for bonds of shorter maturities; and that it accounts for a much higher fraction of yield spreads for junk bonds. We obtain these results by calibrating each of the models - both existing and new ones - to be consistent with data on historical default loss experience. Different structural models, which in theory can still generate a very large range of credit spreads, are shown to predict fairly similar credit spreads under empirically reasonable parameter choices, resulting in the robustness of our conclusion.

Managing market risk in energy

Abstract: The market risks encountered by energy asset operators can be categorized as short term/operational, intermediate term/trading, and long term/valuation in nature. This paper describes how the market risks in operations can be measured and managed using real option models and stochastic optimization techniques. It then links these results to intermediate term value at risk and related risk metrics such as cash flow, earnings, and credit risk which can be used to measure trading risks over weeks to months; and how to optimize these portfolios for risk-return relationships. Finally, it then explores the risks in longer term energy portfolio management and how these can be simulated, measured, and optimized.

Accounting Transparency and the Term Structure of Credit Spreads

Abstract: Theory predicts that the quality of a firm's information disclosure can affect the term structure of its corporate bond yield spreads. Using cross-sectional regression and Nelson-Siegel yield curve estimation, I find that firms with higher AIMR disclosure rankings tend to have lower credit spreads. Moreover, this ``transparency spread'' is especially large among short-term bonds. These findings are consistent with the theory of discretionary disclosure as well as the incomplete accounting information model of Duffie and Lando (2001). The presence of a sizable short-term transparency spread can attenuate some of the empirical problems associated with structural credit risk models.

Does Trade Credit Substitute for Bank Credit? Evidence from Firm-Level Data

Abstract: The paper examines micro data on Italian manufacturing firms` inventory behavior to test the Meltzer (1960) hypothesis according to which firms substitute trade credit for bank credit during periods of monetary tightening. It finds that their inventory investment is constrained by the availability of trade credit. As for the magnitude of the substitution effect, however, this study finds that it is not sizable. This is in line with the micro theories of trade credit and the evidence on actual firm practices, according to which credit terms display modest variations over time.

The Link between Default and Recovery Rates: Theory, Empirical Evidence and Implications

Abstract: This paper analyzes the association between aggregate default and recovery rates on credit assets, and seeks to empirically explain this critical relationship. We examine recovery rates on corporate bond defaults, over the period 1982-2002. Our econometric univariate and multivariate models explain a significant portion of the variance in bond recovery rates aggregated across all seniority and collateral levels. The central thesis is that aggregate recovery rates are basically a function of supply and demand for the securities, with default rates playing a pivotal role. Such a link would bring about a significant increase in both expected and unexpected losses as measured by some widespread credit risk models, and would affect the procyclicality effects of the New Basel Capital Accord. Our results have also important implications for investors in corporate bonds and bank loans, and for all markets (e.g., securitizations, credit derivatives, etc.) which depend on recovery rates as a key variable.

Issues in the Credit Risk Modeling of Retail Markets

Abstract: Retail loan markets create special challenges for credit risk assessment. Borrowers tend to be informationally opaque and borrow relatively infrequently. Retail loans are illiquid and do not trade in secondary markets. For these reasons, historical credit databases are usually not available for retail loans. Moreover, even when data are available, retail loan values are small in absolute terms and therefore application of sophisticated modeling is usually not cost effective on an individual loan-by-loan basis. These features of retail lending have led to the development of techniques that rely on portfolio aggregation in order to measure retail credit risk exposure. BIS proposals for the Basel New Capital Accord differentiate portfolios of mortgage loans from revolving credit loan portfolios from other retail loan portfolios in assessing the bank's minimum capital requirement. We survey the most recent BIS proposals for the credit risk measurement of retail credits in capital regulations. We also describe the recent trend away from relationship lending toward transactional lending, even in the small business loan arena traditionally characterized by small banks extending relationship loans to small businesses. These trends create the opportunity to adopt more analytical, data-based approaches to credit risk measurement. We survey proprietary credit scoring models (such as Fair, Isaac and SMEloan), as well as options-theoretic structural models (such as KMV and Moody's RiskCalc) and reduced form models (such as Credit Risk Plus).

A credit scoring approach for the commercial banking sector

Abstract: For managing credit risk, commercial banks use various scoring methodologies to evaluate the financial performance of client firms. This paper upgrades the quantitative analysis used in the financial performance modules of state-of-the-art credit scoring methodologies. This innovation should help lending officers in branch levels filter out the poor risk applicants. The Data Envelopment Analysis-based methodology was applied to current data for 82 industrial/manufacturing firms comprising the credit portfolio of one of Turkey's largest commercial banks. Using financial ratios, the DEA synthesizes a firm's overall performance into a single financial efficiency score—the “credibility score”. Results were validated by various supporting (regression and discriminant) analyses and, most importantly, by expert judgments based on data or on current knowledge of the firms.

Bank lending policy, credit scoring and value-at-risk

Abstract: This paper builds on the credit-scoring literature and proposes a method to calculate portfolio credit risk. Individual default risk estimates are used to compose a value-at-risk (VaR) measure of credit risk. In general, credit-scoring models suffer from a sample-selection bias. The starting point is therefore to estimate an unbiased scoring model using the bivariate probit approach. The paper uses a large data set with Swedish consumer credit data that contains extensive financial and personal information on both rejected and approved applicants. We study how marginal changes in a default-risk-based acceptance rule would shift the size of the banks loan portfolio, its VaR exposure and average credit losses. Finally, we compare the risk in the sample portfolio with that in an efficiently provided portfolio of equal size. The results show that the size of a small consumer loan does not affect associated default risk, implying that the bank provides loans in a way that is not consistent with default-risk minimization. VaR calculations indicate that an efficient selection (by means of a default-riskbased rule) of loan applicants can reduce credit risk by up to 80%. 2002 Elsevier Science B.V. All rights reserved.

Valuation of Convertible Bonds With Credit Risk

Abstract: Applying the technology of option pricing and contingent claims modeling to credit risk is one of the major growth areas in derivatives research these days. It is an old idea to treat default as a firm9s management rationally exercising the shareholders9 option to go bankrupt rather than to make a required payment to the debtholders. But only in the last few years has this insight been extended and widely applied to practical bond valuation problems. Convertible bonds have also become much more popular in recent years, as the weak and volatile stock market has combined with low interest rates to create an environment in which the conversion option can be very attractive. One critical uncertainty in credit risk analysis that may not be fully appreciated by those who have not worked in this area, is what the payoff to bondholders will actually be in the event of a default. In this article, Ayache, Forsyth, and Vetzal explore the interactions among the multiple options embedded in convertibles that are subject to default risk, call provisions, and put provisions, in addition to the conversion option. Along with results that illustrate the interactions among these multiple options, the authors provide a straightforward valuation technique for convertibles, by applying principles of linear complementarity to the discretization of the fundamental PDE of contingent claims pricing.

Sovereign risk, credibility and the gold standard: 1870–1913 versus 1925–31*

Abstract: Author(s): Obstfeld, Maurice; Taylor, Alan M. | Abstract: What determines sovereign risk? We study the London bond market from the 1870s to the 1930s. Our findings support conventional wisdom concerning the low credibility of the interwar gold standard. Before 1914 gold standard adherence effectively signalled credibility and shaved up to 30 basis points from country borrowing spreads. In the 1920s, however, simply resuming prewar gold parities was insufficient to secure benefits. Countries that devalued before resumption were treated more favorably, and markets scrutinized other signals. Public debt and British Empire membership were important determinants of spreads after World War One, but not before.

Trading Costs in Three U.S. Bond Markets

Abstract: Newly available transaction data are available for comparison of trading costs in the U.S. Treasury bond market with U.S. corporate and municipal bond markets. The mean bid-ask spread per $100 par value is estimated at 23 cents for municipal bonds, 21 cents for corporate bonds, and 8 cents for Treasury bonds. Maturity, trade size, and credit ratings are key determinants of the bid-ask spread. After controlling for credit risk, the bid-ask spread is not statistically different between corporate and Treasury markets but it is higher for municipal bonds relative to Treasuries.

Understanding the Recovery Rates on Defaulted Securities 1

Abstract: We document empirically the determinants of the observed recovery rates on defaulted securities in the United States over the period 1982–1999. The recovery rates are measured using the prices of defaulted securities at the time of default and at the time of emergence from default or from bankruptcy. In addition to seniority and security of the defaulted securities, industry conditions at the time of default are found to be robust and important determinants of the recovery rates. In particular, recovery in a distressed state of the industry (median annual stock return for the industry firms being less than -30%) is lower than the recovery in a healthy state of the industry by 10 to 20 cents on a dollar depending on the measure of recovery employed. The determinants of recovery rates appear to be different from the firm-specific determinants of default risk of the firm. Our results underscore the existence of substantial variability in recoveries, in the cross-section of securities as well as in the time-series, and suggest that in order to capture recovery risk, the credit risk models require an industry factor in addition to the factor representing the firm value.

Default Risk and Diversification: Theory and Empirical Implications

Abstract: Recent advances in the theory of credit risk allow the use of standard term structure machinery for default risk modeling and estimation. The empirical literature in this area often interprets the drift adjustments of the default intensity's diffusion state variables as the only default risk premium. We show that this interpretation implies a restriction on the form of possible default risk premia, which can be justified through exact and approximate notions of ``diversifiable default risk.'' The equivalence between the empirical and martingale default intensities that follows from diversifiable default risk greatly facilitates the pricing and management of credit risk. We emphasize that this is not an equivalence in distribution, and illustrate its importance using credit spread dynamics estimated in Duffee (1999). We also argue that the assumption of diversifiability is implicitly used in certain existing models of mortgage-backed securities.