Bond And CDS Pricing With The Stochastic Recovery Based On KMV Model

When pricing bonds and CDS,the classical KMV model only takes default risk into consideration,which assumes that the recovery rate is a non-random constant.However,various facts show that the recovery risk is an important factor affecting the accuracy of the pricing models.Based on the classical KMV model,this paper introduces recovery risk and re-interprets the PD-LGD relationship.It is found that recovery risk has no impact on probabilities of default(PD)and does have an impact on loss given default(LGD).With the help of the bond and CDS pricing formulas derived from the classical KMV model in the second part of this paper,the bond and CDS pricing in the stochastic recovery based on KMV model can be obtained.