Corporate Financial Distress, Restructuring, and Bankruptcy, 4th Edition
by Edward I. Altman, Edith Hotchkiss, Wei Wang
CHAPTER 16Modeling and Estimating Recovery Rates
Conceptually, three main variables affect the credit risk of a financial asset: (1) the probability of default (PD); (2) the “loss given default” (LGD), which is equal to one minus the recovery rate in the event of default (RR); and (3) the exposure at default (EAD). Earlier in this book, we discussed models and procedures useful for estimating PD of a counterparty in a credit transaction. Of equal importance is estimation of LGD or RR on the defaulted bond or loan (Kalotay and Altman 2017). LGD and RR were among the most important variables underlying the efforts of the Basel Committee when they completed their recommendations in 2004 for specifying capital requirements on credit assets held by banks throughout the world (Basel Committee, 2003).
The RR, usually defined as the market price of the security just after default, is one of the two key variables analyzed by market practitioners in the pricing and other variables in the hugely important credit market. RR is also measured as of the end of the reorganization period, usually Chapter 11, where the rate or amount expected is referred to as the ultimate recovery. Standard & Poor's and Fitch both launched a special category of ratings on RR in the early 2000s, referred to as the recovery rating. This is essentially an estimate of post‐Default ultimate recovery of nominal principal on large commercial and institutional loans. In doing so, both agencies recognized the market's ...