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


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.

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

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

  • $\begingroup$ What about CDOs? $\endgroup$ – quant_dev Feb 12 '11 at 18:24
  • $\begingroup$ 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)? $\endgroup$ – quant_dev Feb 12 '11 at 18:34
  • $\begingroup$ Sorry, thats beyond my scope, but maybe someone else has an answer. $\endgroup$ – Owe Jessen Feb 12 '11 at 21:59

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