Ex Ante Estimation of a Firm's Distress Risk Parameters from Bond Transaction Data

A f irm’s distress r isk can be decomposed into two components: 1) the probability of default on its loan obligations (the likelihood of default) and 2) the amount recovered by bondholders when the firm is in default (the recovery rate).1,2 The goal of this article is to estimate an ex ante measure of the recovery rate from observed bond prices and to study its cross-sectional and temporal variation. Such a study is important because relatively little is known about the recovery rate even though the recovery rate and the default probability jointly determine the outcome when a firm is in financial distress.