Incorporating Systematic Risk in Recovery: Theory and Evidence

AUTHOR Amnon Levy [email protected] Zhenya Hu This paper proposes a theoretical framework to account for systematic risk in recovery and to address the correlation between the firm’s underlying asset process and recovery. Under the proposed framework, the expected value in default under the risk neutral measure can be expressed as a linear function of the expected value under the physical measure. This allows for a simple mapping between expected recovery observed in the data and a measure that can be applied when using risk neutral valuation methods. When calibrating the model to parameters observed in the data, the risk neutral adjustment results in spreads that are 14% higher for a typical bond, and over 30% higher in some cases. When validating against market data, the evidence suggests that market spreads reflect systematic risk in recovery. We found that approximately 80% of our sample was estimated with a lower absolute error when using the risk neutral adjustment to compute model implied spreads. © 2006 Moody’s KMV Company. All rights reserved. Credit Monitor®, EDFCalc®, Private Firm Model®, KMV®, CreditEdge®, Portfolio Manager, Portfolio Preprocessor, GCorr, DealAnalyzer®, CreditMark, the KMV logo, Moody's KMV RiskCalc®, Moody's KMV Financial Analyst®, Moody's KMV Risk Advisor, LossCalc, Expected Default Frequency, and EDF are trademarks of MIS Quality Management Corp. ACKNOWLEDGEMENTS We thank to Navneet Arora, Sayan Chakraborty, Ashish Das, Andrew Kaplin, Qi Li, Yashan Wang, and Bin Zeng for helpful comments. In particular, we thank Greg Gupton for his insights. We would also like to thank seminar participants at Cornell University, INFORMS 2004 annual meeting, and Moody’s KMV. Published by: Moody’s KMV Company To Learn More Please contact your Moody’s KMV client representative, visit us online at www.moodyskmv.com, contact Moody’s KMV via e-mail at [email protected], or call us at: NORTH AND SOUTH AMERICA, NEW ZEALAND AND AUSTRALIA, CALL: 1 866 321 MKMV (6568) or 415 874 6000 EUROPE, THE MIDDLE EAST, AFRICA AND INDIA, CALL: 44 20 7280 8300 FROM ASIA CALL: 813 3218 1160