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Which of the following statements is true:
1. Recovery rate assumptions can be easily made fairly accurately given past data available from credit rating agencies.
2. Recovery rate assumptions are difficult to make given the effect of the business cycle, nature of the industry and multiple other factors difficult to model.
3. The standard deviation of observed recovery rates is generally very high, making any estimate likely to differ significantly from realized recovery rates.
4. Estimation errors for recovery rates are not a concern as they are not directionally biased and will cancel each other out over time.
Recovery rates vary a great deal from year to year, and are difficult to predict. Therefore statement III is true. Similarly, any attempt to predict these is hamstrung by a high standard error, which can be as high as the historical mean itself. The error does not cancel itself out due to the effect of the business cycle making the error directionally biased. Thus statement IV is false.
Statement II is true as these are all factors that make forecasting recovery rates for any credit risk model rather difficult. Statement I is false because recovery rates are difficult to predict and assumptions are not easy to make.