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

Which statement about recovery rates is most consistent with empirical evidence on credit risk?

Empirically, recovery rates are negatively correlated with default rates: when defaults are widespread, as in recessions, recoveries are lower. Seniority and security also raise recovery, so assuming constant recovery understates credit losses in downturns.

  1. ARecovery rates tend to be lower in years when default rates are high, so PD and recovery are negatively correlatedCorrect
  2. BRecovery rates are independent of seniority of the claim
  3. CRecovery rates are higher in recessions because assets are sold at distressed values
  4. DRecovery rates are the same for secured and unsecured debt of the same issuer

Explanation

Empirical studies show that recovery rates fall as default rates rise, which means that assuming a constant recovery understates risk in downturns. Seniority and security matter greatly for recovery.

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