Recovery Assumptions in the Valuation of Credit Derivatives

Abstract

Recovery affects the amount a debtholder receives if a bond issuer defaults. This article examines the impact of recovery rate modeling on risk-neutral default probabilities and the pricing of credit default swaps using a reduced-form model. A multiperiod reduced-form model using different assumptions as to recovery of treasury, of market value, and of face value leads to different expressions for the term structure of risk-neutral default probabilities and the price of credit default swaps. There are small differences for investment-grade and short-maturity default swaps. As the credit quality of an issuer deteriorates, the differences in the risk-neutral default probabilities and default swap prices become more pronounced for the three recovery rate models.