Discount Rate for Workout Recoveries : An Empirical Study

Banks must measure the loss arising from counterparty default in order to achieve Advanced Internal Ratings-Based (IRB) compliance under the proposed Basel II minimum regulatory capital framework. The discount rate to be used on cash received post-default is not agreed upon amongst practitioners and banking supervisors. We review alternative extant proposals and develop a framework for choosing an appropriate discount rate contingent upon the risk of the recovery cash flow. Empirical results are presented by using a comprehensive database of trading prices and workout recoveries of both distressed bonds and loans. We find that discount rates vary significantly by initial issuer ratings, whether or not the industry is in stress at the time of default, relative seniority to other debt and instrument type. The conclusions are found to be robust to potentially confounding determinants of discount rate. Date: September 2006 * The views and opinions expressed here are those of the authors, not necessarily the views and opinions of the authors’ employers, Standard & Poor’s, Federal Reserve Bank of Richmond, the Federal Reserve Board of Governors, or the Federal Reserve System. ** Correspondence should be addressed to Peter Miu, DeGroote School of Business, McMaster University, 1280 Main Street West, Hamilton, Ontario L8S 4M4, Canada, tel: 1-905-525-9140 ext. 23981, fax: 1-905521-8995, email: [email protected].