Estimating Market-implied Recovery Rates fromCredit Default Swap Premia

In this paper, we explore the stochastic nature of implied recovery rates. We exploit the fact that differently-ranking debt instruments of the same issuer face identical default risk but different defaultconditionalrecovery rates. Specifically, we extract information from Credit Default Swaps (CDSs)referencing different types of debt and, in particular, make use of Loan-only Credit Default Swaps, analtogether new asset class. This enables us to overcome a well-known separation problem: In mostCDS pricing equations, loss and default rates are essentially multiplicatively linked, making a dissectionintrinsically difficult. Our approach permits estimating a firm’s entire implied probability distributionof recovery given default at a particular point in time. We allow the mean and the standarddeviation of this distribution to vary stochastically and do not impose any parametric relationship toimplied default rates. Our estimation results are reliable, robust, as well as economically meaningfuland can serve as a basis for deducing firms’ implied probabilities of default.[...]