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Pricing Partners Highlights Issues with Recovery Rate Assumptions - Feb 09

 

Pricing Partners Derivatives-Pricing-Analytics-Independent-Valuation

 

Pricing Partners Highlights Issues with Recovery Rate Assumptions 

Pricing Partners Highlights Issues with Recovery Rate Assumptions and backs out cds recovery rate from bond market to get more accurate independent valuation on credit derivatives.

The current financial crisis has emphasized inaccurate modelling assumptions on credit derivatives. In particular, market participants have realized abruptly after the Lehman default that the standard 40% recovery rate assumption for CDS market was very optimistic as they recover just around 5% of their notional value. This has casted some major doubts about the fair level for recovery rate.
 

In an attempt to bring more accurate valuation on CDS and consequently on all credit derivatives products based on CDS like synthetic CDOs, FTDs, NTDs or any other credit OTC derivatives, Pricing Partners has started to back out the recovery rate from the underlying bond of the CDS. It has observed that the standard 40% recovery rate assumption that is still market practice in the major market data providers is very misleading and very optimistic for distressed names.
 

Eric Benhamou, CEO of Pricing Partners, comments : “There has been a lot of noise around inaccurate modelling assumptions for the simplistic Gaussian copula model for CDO. This is very true but we are surprised that there is much less shout about the inaccurate standard 40% recovery rate assumption. At Pricing Partners, we are doing independent valuation for major clients. We strive hard to question model inputs. Few months ago, we found out that the standard 40% recovery rate assumption was inaccurate and had a substantial impact on CDOs, FTD NTD and comparables. We believe that the proper remarking of recovery rate can explain a great part of the recent investment banks depreciations. As we aim to provide the best quality service in our independent valuation service, we have revisited all our CDS market data to provide more accurate valuation. Backing out CDS recovery rate is in fact a way to relate the CDS and the bond market, with some liquidity spread between these two. For those market participants who have not revisited their CDS recovery assumptions, we expect a substantial PNL impact. As a matter of fact, 40% CDS recovery assumption was just too optimistic pretty much like the assumption commonly used before the subprime crisis that houses prices could not go down. As an independent valuation expert, it is our role to question market inputs and revisit them when we think they are not realistic. And this has been the case of CDS recovery rate for the last few months. Even if it is not an easy task to communicate bad news to client, our vision and our mission is to tell them what we strongly believe is the truth. This is why being independent brings us a great deal of value as we do not have any conflict of interest as none of our shareholders are a bank or trading firm.”
 

Diminishing CDS recovery rate leads mechanically to lower valuation on credit derivatives. For distressed bonds, backing out cds recovery from the bond market can lead to recovery rate as low as 5 to 15 percents. This is very different from the 40 percents we saw before the crisis. On FTDs, lowering recovery rate can drop down valuation price easily by 20 percents.
 

Pricing Partners, www.pricingpartners.com, the independent valuation expert, is a company providing both a pricing library with its own analytics and an independent valuation service on derivatives, making its positioning quite unique. Using a pricing library developed by former professionals of the trading floor, working in investment banks like Goldman Sachs, Natixis, Societe Generale, or HSBC, Pricing Partners provides independent valuation for virtually most of the derivatives, from the vanilla to the most exotic financial products. Its assets coverage is quite extensive and includes derivatives on Interest Rates, Fixed Income, Equity, Inflation, Credit, Foreign Exchange, Commodities, Life Insurance and Hybrid products. 
 

About Pricing Partners

Set up by former professionals of the trading industry, Pricing Partners offers accurate solutions for derivatives products valuation, pricing tools and risk analytics. Thanks to Price-it online, a SaaS platform, Pricing Partners provides independent valuation from the vanilla to the most exotic financial products on most assets (Interest Rates, Fixed Income, Equity, Inflation, Credit, Foreign Exchange, Commodities, Life Insurance and Hybrid products). Pricing Partners develops and commercializes Price-it Excel, an analytic and independent pricing library using a generic payoff language description that allows it to price virtually any financial derivatives. Price-it also supports VaR, CVaR and the most common risk management tools. Pricing Partners is the only company completely mastering the chain of valuation, developing both its own pricing library and a valuation platform giving its clients very accurate and reliable valuation as a result of its intrinsic knowledge of the pricing tools. Pricing Partners solutions can be used by investment banks, buy side firms, hedge funds, financial departments, trading rooms and audit firms.
 
For more information, visit www.pricingpartners.com or contact the Marketing team, marketing@ pricingpartners.com, Tel: +33 1 5526 43 00