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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A bank's analyst estimates that a BBB-rated bond has a real-world one-year default probability of 0.40% and a risk-neutral probability of 1.20%, with an LGD of 60% in both. Which conclusion is most appropriate?

Real-world expected loss is 0.24% (0.40% times 60%), while the risk-neutral loss implied by the spread is 0.72% (1.20% times 60%). The difference, 0.48%, is the compensation for risk premium, not expected loss.

  1. AThe spread's expected-loss component is 0.72%, and the remaining spread of 0.48% for a risk-neutral 0.72% is a risk premium
  2. BThe expected-loss component of the spread is 0.24%, and the risk-neutral loss of 0.72% implies a risk premium of 0.48%Correct
  3. CThe expected loss is 0.72% and there is no premium because LGD is equal
  4. DThe risk premium is 0.80% because it equals the difference in default probabilities

Explanation

Real-world expected loss = 0.40% x 60% = 0.24%. Risk-neutral loss (approximate spread) = 1.20% x 60% = 0.72%. Premium = 0.72% - 0.24% = 0.48%. The 0.80% option forgets to multiply the probability difference by LGD.

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