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Modeling the Recovery Rate in a Reduced
Form Model∗
Xin Guo† Robert A. Jarrow‡ Yan Zeng§
(First Version March 9, 2005)
August 30, 2007
Abstract
This paper provides a model for the recovery rate process in a re-
duced form model. After default, a firm continues to operate, and the
recovery rate is determined by the value of the firm’s assets relative to
its liabilities. The debt recovers a different magnitude depending upon
whether or not the firm enters insolvency and bankruptcy. Although
this recovery rate process is similar to that used in a structural model,
the reduced form approach is maintained by utilizing information re-
duction in the sense of Guo, Jarrow and Zeng (2005). Our model
is able to provide analytic expressions for a firm’s default intensity,
bankruptcy intensity, and zero-coupon bond prices both before and
after default.
KEY WORDS: credit risk, recovery rates, reduced form model,
filtration reduction
∗Helpful comments from seminar participants at Cornell University, the Johannes
Gutenberg-Universitat Mainz, the European Central Bank, Syracuse University, and
SAMSI are gratefully acknowledged.
†224 Rhodes Hall, School of Operations Research and Industrial Engineering, Cornell,
Ithaca, NY 14853; and Department of IEOR, UC at Berkeley, CA 95720-1777. Email:
xinguo@ieor.berkeley.edu. Tel: 510-642-3615. Financial support from NSF CMMI0522342
is gratefully acknowledged.
‡Corresponding author. 451 Sage Hall, Johnson School of Management and Kamakura
Corporation. Email: raj15@cornell.edu. Tel: 607-255-4729. Cornell University, Ithaca,
NY 14853
§Bloomberg. Em
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