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

Which factor is most likely to reduce the recovery rate on a defaulted company's debt, according to common empirical findings on recoveries?

Recoveries tend to be lower when defaults occur in downturns, because industry-wide distress depresses asset values and buyers are scarce. Seniority, collateral, and tangible assets raise recoveries, while default clustering in recessions pushes them down, creating a negative link between default rates and recovery rates.

  1. ADefault occurring during a period of economic expansion
  2. BA higher proportion of senior secured debt held by the claim's class
  3. CDefault occurring in a downturn when industry-wide distress depresses asset valuesCorrect
  4. DStrong tangible asset base of the issuer

Explanation

Recoveries are negatively correlated with default rates; in downturns many firms in an industry fail together and asset values fall, so fire-sale prices reduce recoveries. Seniority, security and tangible assets raise recoveries.

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