The flashcard (Ch 12, 18) says the discount rate should reflect riskiness and credit rating, but ... it then says in projecting anticipated cashflows allow for probability and timing and likely extent of any defaults. Isn't this double counting? Ignoring liquidity risk premium, if we include credit risk allowance in the discount rate, then we should use risk free for discounting. Or did I forget something?
There are several ways to value ABS and in practice. The traditional actuarial approach would use a market GRY based on the credit rating and real-world probabilites. If instead, we used risk-neutral valuation, then we would use risk-free rates and risk-neutral probabilities. However: (1) You are right to suggest that we need to be careful about double counting and allowing for risk twice over. We should use a lower discount rate if we do allow for the probability of default and prepayment in the cashflows, than if we don't. (2) There are other risks on bonds beyond just credit risk, eg market, liquidity.
That was my feeling. Perhaps you should clarify this on the flashcard next time round, as if you use the unadjusted credit rating to base the discount rate on and allow for credit events it will double count. I'm guessing our friend the examiner would not like this.
