Bond and CDS Pricing with Recovery Risk II: The Stochastic Recovery Black-Cox Model

36 Pages Posted: 18 Mar 2015 Last revised: 25 Jan 2017

See all articles by Albert Cohen

Albert Cohen

Michigan State University - Department of Mathematics; Michigan State University - Department of Statistics and Probability

Nick Costanzino

Jefferies Group; New York University - Department of Finance and Risk Engineering

Date Written: January 24, 2017

Abstract

Building on recent work incorporating recovery risk into structural models we consider the Black-Cox model with an added recovery risk driver. The recovery risk driver arises naturally in the context of imperfect information implicit in the structural framework. This leads to a two-factor structural model we call the Stochastic Recovery Black-Cox model, whereby the asset risk driver At defines the default trigger and the recovery risk driver Rt defines the amount recovered in the event of default. We then price zero-coupon bonds and credit default swaps under the Stochastic Recovery Black-Cox model. Introducing separate but correlated risk drivers leads to a decoupling of the default and recovery risk premiums in the credit spread. Finally, we compare our results with the classic Black-Cox model and give explicit expressions for the recovery risk premium in the Stochastic Recovery Black-Cox model.

Keywords: Stochastic Recovery, Recovery Risk, Structural Models, Black-Cox Model

JEL Classification: G12, G33

Suggested Citation

Cohen, Albert and Costanzino, Nick, Bond and CDS Pricing with Recovery Risk II: The Stochastic Recovery Black-Cox Model (January 24, 2017). Available at SSRN: https://ssrn.com/abstract=2579345 or http://dx.doi.org/10.2139/ssrn.2579345

Albert Cohen

Michigan State University - Department of Mathematics ( email )

619 Red Cedar Road
C336 Wells Hall
East Lansing, MI 48824
United States
517-355-4592 (Phone)

HOME PAGE: http://www.math.msu.edu

Michigan State University - Department of Statistics and Probability ( email )

619 Red Cedar Road
C336 Wells Hall
East Lansing, MI 48824-1027
United States
517-355-4592 (Phone)

HOME PAGE: http://www.stt.msu.edu

Nick Costanzino (Contact Author)

Jefferies Group ( email )

520 Madison Ave
Floor 10
New York, NY 10022
United States

New York University - Department of Finance and Risk Engineering

Brooklyn, NY 11201
United States

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