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How do I model the randomness of recovery rate given default when pricing credit derivatives?

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2 Answers 2

up vote 5 down vote accepted

The standard reference is Anderson and Sidenius Extensions to the Gaussian Copula: Random recovery and random factor loadings. Random recovery proved necessary in 2007/2008 when you couldn't calibration standard one factor base correlation models. This paper discusses this, and might be an easier starting point than the Anderson and Sidenius paper.

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Are they still needed? do we use them for anything else than credit tranches? –  quant_dev Feb 14 '11 at 7:19
    
Not sure if it's still needed. I've not done credit in a while. –  ldnquant Feb 14 '11 at 19:39
    
What do you think about the Krekel model? –  quant_dev Feb 15 '11 at 9:41

CreditMetrics uses monte carlo simulation assuming a beta-distribution fitted to historical recovery rates.

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What about CDOs? –  quant_dev Feb 12 '11 at 18:24
    
Also, how do people take into account the correlation of recovery rates and other factors (default times), and go from historical data to the risk-neutral world (if at all)? –  quant_dev Feb 12 '11 at 18:34
    
Sorry, thats beyond my scope, but maybe someone else has an answer. –  Owe Jessen Feb 12 '11 at 21:59

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