Receiving the same fractional recovery of par at default for bonds of the same issuer and seniority, regardless of remaining maturity, has been labelled in the academic literature as a Recovery of Face Value at Default (RFV). Such a recovery form results from language found in typical bond indentures and is supported by empirical evidence from defaulted bond values. We incorporate RFV into an exogenous boundary structural credit risk model and compare its effect to more typical recovery forms found in such models. We find that the chosen recovery form can significantly affect valuation and the sensitivities produced by these models, thus having important implications for empirical studies attempting to validate structural credit risk models. We show that some features of existing structural models are a result of the recovery form assumed in the model and do not necessarily hold under an RFV recovery form. Some of our results complement those found in the literature which examines the endogeneity of the default boundary. We find that some features that may have been solely attributed to modelling the boundary as an optimal decision by the firm can be obtained in an exogenous boundary framework with RFV. This has direct implications for studies which attempt to determine whether endogenous or exogenous models are better supported empirically. We extend our results to incorporate a multifactor default-free term structure model and examine the impact of the recovery form in estimating the cost of debt capital within a structural model framework.
Structural RFV: Recovery Form and Defaultable Debt Analysis
SBUELZ, Alessandro;
2004-01-01
Abstract
Receiving the same fractional recovery of par at default for bonds of the same issuer and seniority, regardless of remaining maturity, has been labelled in the academic literature as a Recovery of Face Value at Default (RFV). Such a recovery form results from language found in typical bond indentures and is supported by empirical evidence from defaulted bond values. We incorporate RFV into an exogenous boundary structural credit risk model and compare its effect to more typical recovery forms found in such models. We find that the chosen recovery form can significantly affect valuation and the sensitivities produced by these models, thus having important implications for empirical studies attempting to validate structural credit risk models. We show that some features of existing structural models are a result of the recovery form assumed in the model and do not necessarily hold under an RFV recovery form. Some of our results complement those found in the literature which examines the endogeneity of the default boundary. We find that some features that may have been solely attributed to modelling the boundary as an optimal decision by the firm can be obtained in an exogenous boundary framework with RFV. This has direct implications for studies which attempt to determine whether endogenous or exogenous models are better supported empirically. We extend our results to incorporate a multifactor default-free term structure model and examine the impact of the recovery form in estimating the cost of debt capital within a structural model framework.
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