FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A risk manager reviewing a distressed credit fund notes that its recovery assumptions are based on historical average recoveries for senior unsecured bonds. Which is the most important reason this could understate loss risk in a downturn?

Recovery rates tend to be lower when default rates are high, because collateral and enterprise values fall together in downturns. Using long-run average recoveries therefore understates losses precisely in stress periods, when defaults and loss severity are positively correlated.

1. ARecovery rates tend to fall when default rates rise, so defaults and low recoveries are positively correlatedCorrect
2. BRecovery rates tend to rise when default rates rise because assets are sold at distressed prices
3. CRecovery rates are constant across the credit cycle by contract
4. DAverage recoveries apply only to equity and not to bonds