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Risks 2017, 5(4), 65; https://doi.org/10.3390/risks5040065

A General Framework for Incorporating Stochastic Recovery in Structural Models of Credit Risk

1
Department of Mathematics, Michigan State University, East Lansing, MI 48824, USA
2
Quantitative Analytics, Barclays Capital, 745 7th Ave, New York, NY 10019, USA
*
Author to whom correspondence should be addressed.
Academic Editor: Mogens Steffensen
Received: 8 September 2017 / Revised: 18 November 2017 / Accepted: 18 November 2017 / Published: 20 December 2017
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Abstract

In this work, we introduce a general framework for incorporating stochastic recovery into structural models. The framework extends the approach to recovery modeling developed in Cohen and Costanzino (2015, 2017) and provides for a systematic way to include different recovery processes into a structural credit model. The key observation is a connection between the partial information gap between firm manager and the market that is captured via a distortion of the probability of default. This last feature is computed by what is essentially a Girsanov transformation and reflects untangling of the recovery process from the default probability. Our framework can be thought of as an extension of Ishizaka and Takaoka (2003) and, in the same spirit of their work, we provide several examples of the framework including bounded recovery and a jump-to-zero model. One of the nice features of our framework is that, given prices from any one-factor structural model, we provide a systematic way to compute corresponding prices with stochastic recovery. The framework also provides a way to analyze correlation between Probability of Default (PD) and Loss Given Default (LGD), and term structure of recovery rates. View Full-Text
Keywords: stochastic recovery; partial information; credit risk; jump-to-default stochastic recovery; partial information; credit risk; jump-to-default
This is an open access article distributed under the Creative Commons Attribution License which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited (CC BY 4.0).
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Cohen, A.; Costanzino, N. A General Framework for Incorporating Stochastic Recovery in Structural Models of Credit Risk. Risks 2017, 5, 65.

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