Is Recovery Risk Priced?

36 Pages Posted: 16 May 2009 Last revised: 26 Feb 2011

See all articles by Marliese Uhrig-Homburg

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance

Timo Schläfer

University of Karlsruhe

Date Written: February 2, 2011

Abstract

The finance literature looks at a number of factors to explain risk premia in corporate debt, such as liquidity effects, jump-to-default risk, and contagion risk. Stochastic re-covery rates as a source of systematic risk have not received much attention so far, most likely due to the difficulties around decomposing the expected loss. In this paper, we exploit the fact that differently-ranking debt instruments of the same issuer face identical default risk but different default-conditional recovery rates. This allows us to isolate implied recovery without any of the rigid assumptions employed by priors. Our results suggest that there is a pronounced systematic component in recovery rates for which investors should receive a premium. By relating our estimates to physical realizations, we make this premium explicit and find it to be quite time-stable and similar for different debt seniorities.

Keywords: Market-implied recovery rate, risk-neutral probability of default, LCDS, CDS, loan-only credit default swap, capital structure, probability distribution of recovery, risk aversion

JEL Classification: G0, G1, G33

Suggested Citation

Uhrig-Homburg, Marliese and Schläfer, Timo, Is Recovery Risk Priced? (February 2, 2011). Available at SSRN: https://ssrn.com/abstract=1405706 or http://dx.doi.org/10.2139/ssrn.1405706

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance ( email )

P.O. Box 6980
D-76049 Karlsruhe, DE
Germany
+49 721 6084 8183 (Phone)
+49 721 6084 8190 (Fax)

HOME PAGE: http://derivate.fbv.kit.edu/english/index.php

Timo Schläfer (Contact Author)

University of Karlsruhe ( email )

Postbox
76128 Karlsruhe, DE 76128
Germany

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