Skip to content

FRM Part I · FRM Exam Part I · Measuring Credit Risk

A portfolio manager observes that recovery rates on senior unsecured bonds tend to fall in years when aggregate default rates are high. Which implication is most accurate for credit risk measurement?

Using the long-run average recovery rate will understate losses in downturns. Recovery rates fall when default rates rise, so loss severity and default frequency worsen together. A constant-recovery model ignores this link and therefore underestimates tail and unexpected losses.

  1. AUsing the long-run average recovery rate will understate losses in downturnsCorrect
  2. BRecovery rates and default rates are independent, so average LGD is appropriate in all states
  3. CNegative correlation between recovery and default lowers unexpected loss versus a constant-recovery model
  4. DRecovery rates should be modeled as a constant because they are less volatile than default probabilities

Explanation

When recoveries fall as defaults rise, losses are worst when defaults are most frequent. A constant average recovery ignores this and understates downturn losses and unexpected loss. The other options contradict the observed negative relationship.

Did you get it right without looking?

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

Practise Measuring Credit RiskFree diagnostic mock

More Measuring Credit Risk questions