Explanation:
Recovery Rate Definition: Recovery rate is defined as the percentage of a bond's face value that investors can expect to recover after a default occurs. It is typically expressed as a percentage of the bond's par value.
Analysis of Options:
Option A: Incorrect - Recovery rate is based on the bond's face value (par value), not the initial purchase price. The initial purchase price could be above or below par, so this would not represent a standard recovery rate definition.
Option B: Incorrect - If the recovery rate is 35%, the bank would take possession of collateral valued at 35% of the bond's face value, not 65%. The 65% represents the loss given default (LGD), which equals 1 - recovery rate.
Option C: Incorrect - This describes probability of default (65%), not recovery rate. Recovery rate and probability of default are distinct concepts in credit risk analysis.
Option D: CORRECT - This accurately describes recovery rate as the value of the bond shortly after default expressed as a percentage of the bond's par value. A 35% recovery rate means investors can expect to recover 35% of the bond's face value after default.
Key Concept: Recovery rate = Value after default / Face value × 100% Loss given default (LGD) = 1 - Recovery rate = 65% in this case
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Which of the following would the trader be correct to identify as an example of a corporate bond that is held by the bank and has a recovery rate of 35%?
A
If the corporate issuer becomes insolvent, liquidation of the issuer's assets would result in the bank receiving 35% of the price it initially paid for the bond.
B
If the corporate issuer defaults on a collateralized bond, the bank would take possession of an amount of collateral valued at 65% of the bond's face value.
C
At the time the bank purchases the bond, there is a 65% unconditional probability that the corporate issuer will not make full and timely payments on the bond.
D
If the corporate issuer defaults on the bond, the value of the bond shortly after default is expected to equal 35% of the bond's par value.