Bond and CDS Pricing with Recovery Risk I : The Stochastic Recovery Merton Model

In this work we incorporate recovery risk into Merton's original credit risk model by introducing a separate risk driver for the recovery process and rationalize this new model within a "partial information" perspective. We show that while adding the recovery risk driver has no impact on probabilities of default (PD), it does have an impact on loss given default (LGD), and on quantities that depend on LGD such as credit prices and spreads. In fact, the addition of recovery risk allows for a mechanism to increase credit spreads, and therefore may account for some of the bond mispricings typical when using Merton's model. Finally, using the new model we price both bonds and CDS, and explicitly compute the price of recovery risk