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

A model validator reviews a credit VaR model that assumes recovery rates are constant at 40% across all obligors and economic states. Which limitation is most relevant?

A constant 40% recovery assumption ignores that recoveries tend to fall when default rates rise. In stress, losses given default are higher exactly when defaults cluster, so the model understates tail losses and credit VaR. The validator should flag it and request stochastic or downturn LGD.

  1. AIt ignores the empirical tendency of recoveries to fall when defaults rise, understating tail lossesCorrect
  2. BIt overstates expected loss because recoveries are too high
  3. CIt makes the model unable to estimate any PD
  4. DIt violates the requirement that VaR be computed at 99%

Explanation

Empirically, recovery rates are negatively correlated with default rates, so in downturns losses given default are higher just when many defaults occur. A fixed recovery assumption removes this source of tail risk and understates high-quantile losses. The other options do not follow from the assumption.

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