Modeling the strongRecoverystrong Rate in a Reduced Form Model.pdf

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