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FRM Part I · FRM Exam Part I · Measuring Credit Risk

A bank holds a senior unsecured bond exposure of USD 100 million with a PD of 3%. Historical recovery rate is 45% on average, but a risk analyst notes that recovery rates tend to fall when default rates rise across the economy. Which statement is most accurate regarding using the average recovery rate for a stress-period loss estimate?

Recovery rates tend to fall when default rates rise, so they are negatively correlated with defaults. Using the average recovery in a stressed period therefore understates loss given default and overall credit loss, because downturn recoveries are lower than average.

  1. AIt overstates loss because recoveries are higher in downturns
  2. BIt is appropriate because recovery is independent of PD in practice
  3. CIt understates loss because recovery and default rates are negatively correlatedCorrect
  4. DIt has no effect because expected loss is unaffected by recovery rates

Explanation

Empirically, recovery rates are negatively correlated with default rates, so downturn recoveries are lower than average and LGD is higher. Using average recovery understates stressed loss. At 45% recovery, expected loss is 100 x 0.03 x 0.55 = USD 1.65 million; if recovery fell to 30%, it would be USD 2.1 million. Expected loss does depend on recovery.

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