Understanding the recovery rates on defaulted securities

Acharya, V, Bharath, S T and Srinivasan, A (2003) Understanding the recovery rates on defaulted securities. Working Paper. London Business School IFA Working Paper.

Abstract

We document empirically the determits of the observed recovery rates on defaulted securities in the United States over the period 19821999. The recovery rates are measured using the prices of defaulted securities at the time of default and at the time of emergence from default or from bankruptcy. In addition to seniority and security of the defaulted securities, industry conditions at the time of default are found to be robust and important determits of the recovery rates. In particular, recovery in a distressed state of the industry (median annual stock return for the industry firms being less than 30%) is lower than the recovery in a healthy state of the industry by 10 to 20 cents on a dollar depending on the measure of recovery employed. The determits of recovery rates appear to be only partly correlated to the firmspecific determits of default risk of the firm. Our results underscore the existence of substantial variability in recoveries, in the crosssection of securities as well as in the timeseries, and suggest that in order to capture recovery risk, the next generation of credit risk models should include an industry factor in addition to the factor representing the firm value or the default process.