A Short Note on Market-Consistent Calibration of Static Recovery Rates

In proceedings: International Conference on Operations Research, 2011.

9 Pages Posted: 12 Feb 2010 Last revised: 13 Aug 2014

See all articles by Chris Kenyon

Chris Kenyon

MUFG Securities EMEA plc; University College London

Ralf Werner

Universität Augsburg

Date Written: February 11, 2010

Abstract

The elephant in the room around CDS, CMBS, CMBX, and CDO pricing is the recovery rate. Practically, whilst recovery swaps exist they are not liquid. The problem is especially acute when upfront payments, or quoted prices, contradict previous recovery rate assumptions, e.g. pre-crisis, 40% for equities, or up to 80% (or more) for some CMBS. Although recoveries will decrease as rating drop, ratings are not always in sync with market movements. This is exacerbated when CDS-on-CMBS are considered, either with pay-as-you-go CDS, or (for tranches thinner than one commercial mortgage) standard CDS. Theoretical developments have run ahead of market reality for calibration. Whilst CDS and CDO reduced-form models exist for stochastic hazard rates and stochastic recovery rates actual calibration is problematic. In this paper we take a step backwards and consider a dynamic calibration of traditional static CDS models to market data. We start from the usual daily model recalibration and propose heuristics for market-consistent calibration of static data, specifically the recovery rate within static hazard rate models. These are based on strong constraints on recovery rates from observed CDS prices. Note that this static approach is complementary to the dynamic RMV and is advantageous in that standard CDS and CDO pricing is unchanged. These heuristics can be extended and generalized in different ways within stochastic models. For example the market-implied recovery rate that is now an output can be the input for a stochastic recovery rate model e.g. Charaf08,Yadong09,Werpachowski09 (all on SSRN).

Keywords: recovery rates, CDS, stochastic models, CDO

JEL Classification: G12, G13, C63

Suggested Citation

Kenyon, Chris and Werner, Ralf, A Short Note on Market-Consistent Calibration of Static Recovery Rates (February 11, 2010). In proceedings: International Conference on Operations Research, 2011., Available at SSRN: https://ssrn.com/abstract=1551387 or http://dx.doi.org/10.2139/ssrn.1551387

Chris Kenyon (Contact Author)

MUFG Securities EMEA plc ( email )

25 Ropemaker St
London, EC2Y 9AJ
United Kingdom

University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

Ralf Werner

Universität Augsburg ( email )

Augsburg
Germany

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
197
Abstract Views
1,997
Rank
278,522
PlumX Metrics