Rickard Rönblom presents his master's thesis

Interpreting the relative spread
-Recovery rate modeling based on senior and subordinated CDS spreads

Abstract


 This thesis investigates if the relative spread, defined as the ratio
of senior to subordinated CDS (credit default swap) spread, can be
used to observe differences in expected recovery rates between
companies and over time. A model called the Aggregate recovery
framework (ARF) is formed where the relative spread is used as an
input to estimate the risk-neutral probability distribution of the
aggregate recovery rate over total senior unsecured and subordinated
liabilities. The risk-neutral senior and subordinated CDS recovery
rates are then modeled as functions of the aggregate recovery rate.
   A possible application of the ARF is to model the prices of digital
default swap (DDS) and recovery swap contracts. Given that the CDS
market is more liquid than the DDS and recovery swap market, the
framework could be used to observe changes in the fair price of these
contracts between trades.
   In the empirical study, the ARF is applied on CDS data covering 30 mayor
banks around the time of the American subprime mortgage crises. The impact
of the crisis on the expected recovery rates is estimated as well as
differences in expected recovery rates between the companies.
   The results show an average decline in the implied senior recovery rate
of around 6 percent points from before the crisis. There is also a decline
in the implied subordinated recovery rate but these results are more
uncertain. Differences in implied recovery rates between the companies
are pointed out as well. The differences are however sensitive to
variations in the expected rate of priority violation between the
companies. The accuracy of these results is therefore questionable.
   The determinants of priority violation in bankruptcy resolutions are
rather unexplored. By studying the dynamics of this parameter, it is
possible that the model could be further improved.