#06-18
How Much of a Haircut? Options-Based Structural Modeling of Defaulted Bond Modeling Rates
Robert R. Cangemi, Jr., Joseph R. Mason, and Michael S. Pagano, August 2006
Abstract: The present paper characterizes the problem of estimating recoveries on defaulted debt in a real
options optimal stopping framework that takes account of put-call parity conditions embedded
within corporate capital structures. The paper hypothesizes that an optimal stopping problem can
theoretically explain a large amount of the variability in losses on defaulted corporate debt
securities, and that augmenting this approach by estimating in a system of equations that
accounts for put-call parity conditions adds considerable explanatory power. Empirical tests with
a large number of corporate defaults confirm the usefulness of the approach. Moreover, the
approach creates a powerful framework for analyzing investor behavior across the business
cycle. Increased volatility, combined with time-varying net discount rates around business cycle
turning points, can result in stakeholders waiting longer in search of additional returns before
renegotiating the debt “haircut,” that is, the reduction in face value of debt and/or increase in
stated maturity necessary to resolve the default.
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