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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A bank's model estimates a loan's loss given default. Which fact about historical recovery rates is most consistent with the observation that recoveries vary by seniority?

Senior secured debt has historically recovered more than subordinated debt, because senior creditors have priority claims on the firm's assets in bankruptcy. Recovery rates therefore differ systematically by seniority, and loss given default models should reflect the debt's rank.

  1. ASenior secured debt has typically recovered more than subordinated debtCorrect
  2. BSubordinated debt has typically recovered more than senior secured debt
  3. CAll seniority classes recover identical fractions of face value
  4. DRecovery depends only on bond maturity, not seniority

Explanation

Seniority determines priority of claims in bankruptcy, so senior secured creditors typically recover more than junior or subordinated ones. The other statements contradict the absolute priority ordering observed in the data.

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