Empirical Evidence for the Structural Recovery Model

Abstract

While defaults are rare events, losses can be substantial even for credit portfolios with a large number of contracts. Therefore, not only a good evaluation of the probability of default is crucial, but also the severity of losses needs to be estimated. The recovery rate is often modeled independently with regard to the default probability, whereas the Merton model yields a functional dependence of both variables. We use Moody's Default and Recovery Database in order to investigate the relationship of default probability and recovery rate for senior secured bonds. The assumptions in the Merton model do not seem justified by the empirical situation. Yet the empirical dependence of default probability and recovery rate is well described by the functional dependence found in the Merton model.