Skip to content

FRM Part II · FRM Exam Part II · Credit Value at Risk

A bank reviews LGD for senior unsecured loans and finds that realized recovery rates are lower in years when default rates are high. What is the main implication for credit risk measurement?

Because recovery rates fall when default rates rise, an average LGD understates losses in downturns. Risk measurement should therefore use downturn or stressed LGD that reflects the dependence between PD and recovery.

  1. ALGD is independent of PD, so using the average LGD is unbiased in stress
  2. BUsing average LGD understates losses in downturns, so a downturn LGD is appropriateCorrect
  3. CRecovery rates should be ignored because PD captures all loss variation
  4. DLGD should be set to zero for secured and unsecured loans alike

Explanation

Negative correlation between recovery and default rates means losses are higher exactly when defaults cluster. Average LGD would therefore understate stressed losses, motivating downturn LGD estimates.

Did you get it right without looking?

One question tells you little. A timed set on Credit Value at Risk shows your real accuracy, how long you take and where you lose marks.

Practise Credit Value at RiskFree diagnostic mock

More Credit Value at Risk questions