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According to ISDA standard (also here), the recovery rate for senior unsecured is 40%, that of subordinate is 20%, and emerging markets is 25% (both senior and subordinate).

I wonder the rationale of applying higher recovery rate of emerging markets (subordinate) than that of the subordinate in developed countries. Could anyone explain the rationale of applying certain recovery rate for senior unsecured, subordinate and emerging markets assumed by ISDA? Is there any reference explaining such assumption on recovery rate?

Thanks

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  • $\begingroup$ It's really just a pricing convention, so that everyone agrees on the dollar value of a contract quoted in spread. It doesn't mean, necessarily, that that recovery rate goes into the actual pricing and risk decisions. $\endgroup$
    – Brian B
    Commented Oct 3, 2013 at 16:16
  • $\begingroup$ I do not really get it. You mean that the certain recovery rate is just taken by convention? What are the usual market practice in estimating or applying the recovery rate? $\endgroup$
    – Dennis
    Commented Oct 6, 2013 at 22:36

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If the contract is actually triggered, then it will pay out depending on the actual recovery rate of the particulars of the circumstance.

To recap:

  1. nominal CDS recovery rate in ISDA docs - used as a convention in the pricing of CDS contracts (spread vs upfront etc). Has nothing to do with any particular credit event.
  2. expected recovery rate - modeled when pricing bonds, the expectation of bond recovery in the event of a default/credit event.
  3. actual realized recovery rate - how much the bonds are actually trading for when a credit event is declared, which determines the actual realized payout from the CDS contract.
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Presuming the question refers to CDS pricing:

Note that a contract pays out on a credit event (no matter the scale of losses), while the value of the contract also depends on the value that can be recovered (see *NB below). So in agreeing the price of a contract you have two variables to settle on (probability of an event, and the recovery rate). To avoid a having a matrix of different contracts (i believe it started as such), and introduce some standardization, most (all?) CDS contracts will now use a standardized recovery rate as a pricing convention only (says nothing about the actual eventual recovery rate in case of default). Given this, the price depends only on one variable, the probability of default.

*NB Given a market price for a CDS, the higher the recovery rate you assume, the higher the default probability implied.

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  • $\begingroup$ Either you didn't write what you mean, or you just don't understand how this works. experquisite's answer is much better. $\endgroup$
    – quant_dev
    Commented Oct 10, 2013 at 11:58
  • $\begingroup$ I explained as i understand it. If I'm wrong in my understanding, which of course can be the case, can you please elaborate on your critique. $\endgroup$
    – Yugmorf
    Commented Oct 15, 2013 at 14:07
  • $\begingroup$ Read the 2nd answer, it's all there. $\endgroup$
    – quant_dev
    Commented Oct 15, 2013 at 16:16
  • $\begingroup$ Yes, but could you please explain which part i wasn't understanding correctly (since you stated such in your comment). If you are knowledgeable about this subject then i think it's good you can share it, no? $\endgroup$
    – Yugmorf
    Commented Oct 16, 2013 at 1:50

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