Abstract
This paper derives the theoretical underpinnings behind the following observed empirical facts in credit risk modeling: The probability of default, the seniority, the thickness of the tranche, the debt cushion, and macroeconomic factors are the important determinants of the conditional probability density function of the recovery rate given default (RGD) of a firm’s debt and its tranches. In a portfolio of debt securities, the conditional probability density functions of the recovery rate given default of tranches have point probability masses near zero and one, and the expected value of the recovery rate given default increases as the seniority or debt cushion increases. The paper derives other results as well, such as the fact that the conditional probability distribution function associated with any senior tranche dominates that of any junior tranche by first-order. The standard deviation of the recovery rate given default of a senior security need not be greater than that of a junior security. It is proved that the expected value of the recovery rate given default need not increase as the proportional thickness of the tranche increases.
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callMore From: International Journal of Theoretical and Applied Finance
Disclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
