Bruche, Max and Gonzalez-Aguado, Carlos (2006) Recovery rates, default probabilities and the credit cycle. Discussion paper, 572. Financial Markets Group, London School of Economics and Political Science, London, UK.
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Recovery rates are negatively related to default probabilities (Altman et al., 2005). This paper proposes and estimates a model in which this dependence is the result of an unobserved credit cycle: When times are bad, the default probability is high and recovery rates are low; when times are good, the default probability is low and recovery rates are high. The proposed dynamic model is shown to produce a better fit to the data than a standard static approach. It indicates that ignoring the dynamic nature of credit risk could lead to a severe underestimation of credit risk (e.g. by a factor of up to 1.7 in terms of the 95% VaR). Also, the model indicates that the credit cycle is related to but distinct from the business cycle as e.g. determined by the NBER, which might explain why previous studies have found the power of macroeconomic variables in explaining default probabilities and recoveries to be low.
|Item Type:||Monograph (Discussion Paper)|
|Additional Information:||© 2006 The Authors|
|Uncontrolled Keywords:||Credit, Recovery rate, Default probability, Business cycle, Capital requirements, Markov chain|
|Library of Congress subject classification:||H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
|Journal of Economic Literature Classification System:||G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation
G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy; Liquidation
G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
|Sets:||Research centres and groups > Financial Markets Group (FMG)
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