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Bjørn Eraker
90.0 5.0
80.0 4.0
3.0
70.0
2.0
Percent of par value
60.0
1.0
Percent
50.0
0.0
40.0
-1.0
30.0
-2.0
20.0
-3.0
10.0 -4.0
0.0 -5.0
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
Year of default
Figure: Historical recovery rates and GDP growth. From the paper
“An Empirical Analysis of Bond Recovery Rates: Exploring a
Structural View of Default” by Daniel Covitz and Song Han, The
Federal Reserve Board
VT = (1 − p)(100 + c) + pX
and so on.
T
!
(1 − p)T X (1 − p)t
B0 = (1 − p) 100 + c
(1 + y )T (1 + y )t
t=1
T
X (1 − p)t
+ pX (1)
(1 + y )t
t=0
1 1−p
∗
=
1+y 1+y
or
1+y
y∗ = −1
1−p
For example, if y = 0.01 and the default probability is p = 0.01
then
y ∗ = 0.0202
or with y = 0.02 and p = 0.04
y ∗ = 0.0625
etc.
We see that y ∗ ≈ y + p.
T
!
1 X 1
B0 = (1 − p) 100 + c
∗
(1 + y )T (1 + y ∗ )t
t=1
T
X 1
+p X (2)
(1 + y ∗ )t
t=0
In other words, we can discount the bond’s cash flows using the
“default adjusted ytm” y ∗ and probability weigh the value with
and without default.
T T
100 X 1 p X 1
B0 = + ∗
c + X (3)
∗
(1 + y )T (1 + y )t 1−p (1 + y ∗ )t
t=1 t=1
100 p
B0 = ∗ T
+ A(y ∗ , T )c + A(y ∗ , T )X (5)
(1 + y ) 1−p
1 + y ∗ = 1.0531 = 1.0285/(1 − p)
p = 0.0542
We find this by solving eqn. (5) for p so that the bond coupon
equals the stated 5.31% and the bond is selling at par.
Similarly we find
p = 0.0578
for the single A rated group.
See that the heuristics from the one period example holds
approximately in the graph.
For example, in the above example p = 0.0364.
Graph on next page gives more details
X=0
0.25
X = 25
X = 50
X = 75
0.2
0.15
Probability
0.1
0.05
ï0.05
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
Spread
15%
0.08 25%
50%
0.07
0.06
credit spread
0.05
0.04
0.03
0.02
0.01
0
0 2 4 6 8 10 12 14 16 18 20
maturity
0.035
0.03
0.025
credit spread
0.02
0.015
0.01
0.005
0
0 2 4 6 8 10 12 14 16 18 20
maturity