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Article

A Modified Reduced-Form Model with Time-Varying Default and Recovery Rates and Its Applications in Pricing Convertible Bonds

Jr-Yan Wang and Tian-Shyr Dai
The Journal of Derivatives Summer 2017, 24 (4) 52-79; DOI: https://doi.org/10.3905/jod.2017.24.4.052
Jr-Yan Wang
is an associate professor in the Department of International Business at National Taiwan University in Taipei, Taiwan
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Tian-Shyr Dai
is a professor and chairman of the Department of Information and Finance Management at National Chiao Tung University in Hsinchu, Taiwan
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Abstract

Reduced-form models of default risk require estimates of the recovery rate, or equivalently, the loss given default. In many cases, this is simply set at a fixed recovery rate of 40%. But the 40% rate is often far from the realized recovery amount in practice, and empirical research shows that recoveries are negatively related to ex ante default probabilities and the rate varies over time. In this article, the authors incorporate a regression-based estimate of the current recovery rate from historical data, modeling it as a function of the default probability and, potentially, macroeconomic data such as growth of the S&P Index. They then build this relationship into a lattice structure and show how it can be applied to price convertible bonds.

  • © 2017 Institutional Investor, Inc.
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The Journal of Derivatives: 24 (4)
The Journal of Derivatives
Vol. 24, Issue 4
Summer 2017
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A Modified Reduced-Form Model with Time-Varying Default and Recovery Rates and Its Applications in Pricing Convertible Bonds
Jr-Yan Wang, Tian-Shyr Dai
The Journal of Derivatives May 2017, 24 (4) 52-79; DOI: 10.3905/jod.2017.24.4.052

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A Modified Reduced-Form Model with Time-Varying Default and Recovery Rates and Its Applications in Pricing Convertible Bonds
Jr-Yan Wang, Tian-Shyr Dai
The Journal of Derivatives May 2017, 24 (4) 52-79; DOI: 10.3905/jod.2017.24.4.052
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  • Article
    • Abstract
    • MODIFIED REDUCED-FORM MODEL
    • PRICING CBS SUBJECT TO DEFAULT RISK
    • DANAHER’S CB EXAMPLE
    • A POSSIBLE EXTENSION FOR OUR MODIFIED REDUCED-FORM MODEL
    • CONCLUSION
    • ENDNOTES
    • REFERENCES
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