In portfolio management, which statement about recovery rate is true?

In portfolio management, which statement about recovery rate is true?

• A. It is calculated as total outstanding divided by total collected.
• B. It is simply the ratio of accounts paid in full to total accounts.
• C. It is used to assess portfolio performance and set reserves.
• D. It represents the percentage of assets seized.

Answer: (C)

Recovery rate measures how much of the money at risk you actually collect after a borrower defaults. It’s a key input for judging how a portfolio performs because it directly affects the losses you recognize and the reserves you must hold against potential future defaults. When you know your expected recovery, you can estimate the true loss given default (LGD) as 1 minus the recovery rate, which in turn feeds into broader credit-risk metrics like expected credit losses. That’s why this metric is used to assess portfolio performance and to set reserves. The other statements mischaracterize what recovery rate represents. It isn’t simply total outstanding divided by total collected, nor just the ratio of accounts paid in full, since recoveries can come from partial repayments and from collateral liquidations. It also isn’t the percentage of assets seized alone; recovery rate focuses on what portion of the exposure you actually recover, not just what collateral is taken.

Recovery rate measures how much of the money at risk you actually collect after a borrower defaults. It’s a key input for judging how a portfolio performs because it directly affects the losses you recognize and the reserves you must hold against potential future defaults. When you know your expected recovery, you can estimate the true loss given default (LGD) as 1 minus the recovery rate, which in turn feeds into broader credit-risk metrics like expected credit losses. That’s why this metric is used to assess portfolio performance and to set reserves.

The other statements mischaracterize what recovery rate represents. It isn’t simply total outstanding divided by total collected, nor just the ratio of accounts paid in full, since recoveries can come from partial repayments and from collateral liquidations. It also isn’t the percentage of assets seized alone; recovery rate focuses on what portion of the exposure you actually recover, not just what collateral is taken.