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

A credit analyst reviewing historical bond data for a risk report observes that, across years, the average recovery rate on defaulted senior unsecured bonds is lower in years when the aggregate default rate is high. Which statement best describes this relationship?

Recovery rates are negatively correlated with default rates: when many firms default in a downturn, asset values and recoveries fall. Assuming a constant recovery rate therefore understates expected losses during stressed periods, when losses matter most for risk measurement.

  1. ARecovery rates are negatively correlated with default rates, so using a fixed recovery assumption can understate losses in downturnsCorrect
  2. BRecovery rates are positively correlated with default rates, so a fixed assumption overstates losses in downturns
  3. CRecovery rates are independent of default rates, so a fixed assumption is unbiased in all years
  4. DRecovery rates are determined only by the coupon rate, so the default rate has no bearing

Explanation

Empirical evidence shows recovery rates tend to fall when default rates rise, because the same economic conditions that drive defaults also depress collateral and asset values. A constant recovery assumption therefore understates losses in stress periods. Positive correlation or independence contradicts the evidence.

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