The Role of Market-Implied Severity Modeling for Credit VaR

J. Samuel Baixauli

and

Susana Alvarez

In this paper a beta-component mixture is proposed to model the market-implied severity. Recovery rates are extracted and identified from credit default swaps instead of using defaulted bonds instead using defaulted bonds because it allows us to identify recovery rates of low probability of default companies. An empirical analysis is carried out and the results show that a single beta distribution is rejected as a correct specification for implied severity while a beta-component mixture is accepted. Furthermore, the importance of this modeling approach is highlighted by focusing on its role for credit VaR.