Recovery rate

[Imad]

Hi David,

Hope you are well.
When we talk about recovery rate, we refer to the creditors (liability side of the bank) and not the debtors (asset side of the bank).

I am a bit confused because I came accross an exemple where it mentions the recovery rate of the firm's traded bonds. This implies the bonds issued by the firm as a mean of financing and NOT the bonds the firm purchased in open market.

Could you please clarify.

Thanks
Imad

 

[ShaktiRathore]

Hi,
Please don't get confused here. The recovery rate always given by 1-LGD so that the amount that is recoverable after the default by the bond. Now whether the bond id issued by the firm or it is an investment by the firm does not matter. What matters is that what is the recovery rate of the bond whether it is issued by the firm or invested by the firm. Please don't get confused by the asset and liability side of the firm.
If firm issues the bond what is its recovery rate that is how much firm can give to bondholders in case of default on the bonds. And what the firm can get in case of default if the firm holds the bonds as an asset/investment.

i hope its clear
thanks

 

[David Harper CFA FRM]

I agree with Shakti. We tend to treat recovery rate (RR) = 1 - LGD as a ex ante (what is the model's estimate of recovery/loss?) feature of an exposure (instrument or facility) rather than either a function of its balance sheet status or even its other characteristics like traded bond-versus-loan or seniority. All secondary securities (e.g., bonds issued by a bank), by definition, are both a liability to some firm (issuing bank) and an asset to the buyer (their exposure). In your example, the bonds may be a liability, so they don't represent an exposure (asset) to the issuing bank, rather they are a funding source, but they can still have an associated estimated LGD, which to my knowledge does not directly impact them (I don't think it's a liability valuation input?) ... rather it's a parameter of the instrument, primary of interest to those who would carry as an asset (exposure). Thanks,