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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A bank's analyst reviews a portfolio and notes that during economic downturns observed default rates rise and realized recovery rates on defaulted loans fall at the same time. If the bank estimates expected loss using long-run average PD and long-run average LGD multiplied together, what is the most likely consequence?

Expected loss is understated in downturns. Default rates and loss severities rise together, so PD and LGD are positively correlated, and the expected product exceeds the product of the long-run averages. Multiplying average PD by average LGD ignores this covariance and underestimates losses in stressed conditions.

  1. AExpected loss in downturn conditions is understated because PD and LGD are positively correlatedCorrect
  2. BExpected loss is overstated because the two effects offset each other
  3. CExpected loss is unaffected because PD and LGD are independent by construction
  4. DExpected loss is understated only if exposure at default is fixed

Explanation

When PD and LGD rise together, the expectation of the product exceeds the product of averages (covariance is positive). Multiplying long-run averages therefore understates downturn loss. Option C assumes independence, which the scenario contradicts.

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