Recovery Rates in investment-grade pools of credit assets: A large deviations analysis

TL;DR

This paper analyzes how recovery rates affect losses in large pools of credit assets using large deviations theory, revealing the most likely loss configurations and providing numerical illustrations.

Contribution

It introduces a large deviations framework to study recovery-dependent losses in diverse credit pools, offering a novel analytical approach.

Findings

Rate function has a natural interpretation as the favored loss-recovery rearrangement.

Provides explicit numerical examples illustrating the theoretical results.

Shows the structure of losses in pools with a continuum of asset types.

Abstract

We consider the effect of recovery rates on a pool of credit assets. We allow the recovery rate to depend on the defaults in a general way. Using the theory of large deviations, we study the structure of losses in a pool consisting of a continuum of types. We derive the corresponding rate function and show that it has a natural interpretation as the favored way to rearrange recoveries and losses among the different types. Numerical examples are also provided.