RecoveryRates;Moody's:1982to2010(Table 16.2, page 352)ClassAveRecRate(%)65.8First lien bank loan29.1Second lienbankloan47.8Seniorunsecuredbankloan50.8Senior secured bondSeniorunsecuredbond36.730.7Seniorsubordinatedbond31.3Subordinatedbond24.7Juniorsubordinatedbond11RiskManagementandFinancialInstitutions3e,Chapter16,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 16, Copyright © John C. Hull 2012 Recovery Rates; Moody’s: 1982 to 2010 (Table 16.2, page 352) 11 Class Ave Rec Rate (%) First lien bank loan 65.8 Second lien bank loan 29.1 Senior unsecured bank loan 47.8 Senior secured bond 50.8 Senior unsecured bond 36.7 Senior subordinated bond 30.7 Subordinated bond 31.3 Junior subordinated bond 24.7
Recovery Rates Depend onDefaultRatesMoody's best fit estimate for the 1982 to2007 period isAve Recovery Rate:59.33- 3.06 × Spec GradeDefault RateR2 of regressionis about 0.512RiskManagementandFinancialInstitutions3e,Chapter16,CopyrightJohnC.Hull2012
Recovery Rates Depend on Default Rates ⚫ Moody’s best fit estimate for the 1982 to 2007 period is Ave Recovery Rate = 59.33 − 3.06 ×Spec Grade Default Rate ⚫ R2 of regression is about 0.5 Risk Management and Financial Institutions 3e, Chapter 16, Copyright © John C. Hull 2012 12
Credit Default Swaps (page 352)Buyer of the instrument acquires protection from theseller against a default by a particular company orcountry (the reference entity)Example: Buyer pays a premium of 90 bps per yearfor $1o0 million of 5-year protection against companyXPremiumis known asthe credit defaultspread. Itispaid for life of contract or until defaultIf there is a default, the buyer has the right to sellbonds with a face value of $100 million issued bycompany X for$1o0 million (Several bonds may bedeliverable)RiskManagementandFinancialInstitutions3e,Chapter16,CopyrightJohnC.Hull201213
Risk Management and Financial Institutions 3e, Chapter 16, Copyright © John C. Hull 2012 Credit Default Swaps (page 352) ⚫ Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity) ⚫ Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year protection against company X ⚫ Premium is known as the credit default spread. It is paid for life of contract or until default ⚫ If there is a default, the buyer has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds may be deliverable) 13
CDS Structure (Figure 16.1, page 354)90bpsperyearDefaultDefaultProtectionProtectionBuyer, ASeller, BPayoff ifthere isa default byreference entity=100(1-R)Recoveryrate,R,istheratioofthevalueofthebondissuedbyreferenceentityimmediatelyafterdefaulttothefacevalueof thebondRiskManagementandFinancialInstitutions3e,Chapter16,CopyrightJohnC.Hull201214
Risk Management and Financial Institutions 3e, Chapter 16, Copyright © John C. Hull 2012 CDS Structure (Figure 16.1, page 354) Default Protection Buyer, A Default Protection Seller, B 90 bps per year Payoff if there is a default by reference entity=100(1-R) Recovery rate, R, is the ratio of the value of the bond issued by reference entity immediately after default to the face value of the bond 14