Estimating recovery discount rates: A methodological note

Abstract

Loss given default (LGD) is a key input in credit risk measurement proceses. LGD rates are determined in part by the recoveries on defaulted credits. Recoveries are uncertain in value, and the time of recoveries is subject to long and variable lags. In order to estimate LGD, it is necessary to estimate the market value of an uncertain recovery stream at the time a credit defaults. This calculation requires a forecast for the expected recovery stream as well as an estimate of the risk-adjusted discount rate for discounting expected recovery values. Some commercially available recovery databases are now available that may be utilised to estimate risk premia for a class of defaulted credits. This methodological note discusses the quantitative issues and methods that are associated with estimating recovery distributions and their associated market risk premia.