Recovery Rate Assumptions

Pricing a credit default swap or a defaultable bond requires two ingredients: how likely is default (the hazard rate), and if default happens, how much do you get back? That second number is the recovery rate, and it's routinely the least-examined assumption in the whole model — many desks simply plug in an industry-standard 40% for senior unsecured debt regardless of the specific issuer, even though actual recoveries for corporate defaults have historically ranged from near zero to nearly full repayment.

Why the assumption matters

CDS pricing depends on recovery mainly through the loss given default, $1$ minus the recovery rate, which scales the payout a protection buyer receives. But recovery rate and default probability aren't pinned down separately by CDS spreads alone — a given spread can be explained by a high default probability with low recovery, or a lower default probability with even lower recovery, so market convention just fixes recovery at a standard level (40% senior unsecured, 20% subordinated) to back out an implied hazard rate, rather than trying to estimate both jointly.

Worked example

A CDS trades at a spread implying a hazard rate calculated under the standard 40% recovery assumption. If the issuer's actual capital structure is unusually asset-heavy with strong collateral (suggesting a more realistic 60% recovery), the same spread implies a materially higher true default probability than the 40%-assumption calculation would suggest — recovery and default probability trade off against each other in a way a single CDS spread cannot separately reveal.