Skip to content

FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A bank calibrates the Merton model to a firm and obtains a risk-neutral default probability. It then compares this with the historical (real-world) default frequency for similarly rated firms. Which statement best describes the typical finding and its correct use?

Risk-neutral default probabilities are typically higher than real-world ones because they include a risk premium. They suit pricing and valuation, but using them for expected loss, capital or scenario analysis would overstate default risk.

  1. ARisk-neutral probabilities are typically higher than real-world ones, so they are suited to pricing credit instruments but overstate expected losses if used for scenario analysis or capitalCorrect
  2. BRisk-neutral probabilities are typically lower than real-world ones, so they are suited to economic capital
  3. CThe two are identical because the Merton model removes risk premiums
  4. DRisk-neutral probabilities are higher, so they are the correct input for calculating real-world expected loss

Explanation

Credit spreads embed risk premiums, so market-implied (risk-neutral) default probabilities exceed historical ones. They are appropriate for valuation, while real-world probabilities should be used for expected loss, capital and scenario analysis. Using risk-neutral values for the latter overstates the loss.

Did you get it right without looking?

One question tells you little. A timed set on Estimating Default Probabilities shows your real accuracy, how long you take and where you lose marks.

Practise Estimating Default ProbabilitiesFree diagnostic mock

More Estimating Default Probabilities questions