Skip to content

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

A bank must choose the default probability to use in two tasks: (A) pricing a credit default swap for a trading desk mark-to-market, and (B) calculating a scenario analysis of expected credit losses over the next year for provisioning. Which assignment is most appropriate?

Use risk-neutral probabilities for pricing and marking the CDS to market, since they are calibrated to market prices, and real-world probabilities for projecting actual losses and provisions. Risk-neutral values include risk premia and would overstate expected losses in scenario analysis.

  1. AReal-world for A and risk-neutral for B
  2. BRisk-neutral for both, because market prices reflect all information
  3. CReal-world for both, because only actual defaults matter
  4. DRisk-neutral for A and real-world for BCorrect

Explanation

Valuing instruments consistently with market prices requires risk-neutral probabilities, which are calibrated to traded spreads. Estimating actual expected losses or stress outcomes requires real-world probabilities. Using risk-neutral for provisioning would overstate losses because it includes risk premia.

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