FRM Part I · FRM Exam Part I · Corporate Bonds
A bond has a quoted spread over the risk-free curve of 160 bps. Analysts estimate the expected-loss component from default at 60 bps. Assuming the remainder is compensation only for illiquidity and risk premia other than expected default loss, and the illiquidity share is 70% of that remainder, what is the illiquidity component in bps?
The illiquidity component is 70 bps. Subtract the 60 bps expected default loss from the 160 bps spread to get 100 bps, then take 70% of that remainder as the illiquidity compensation.
- A42 bps
- B70 bpsCorrect
- C112 bps
- D100 bps
Explanation
Remainder = 160 - 60 = 100 bps. Illiquidity = 70% x 100 = 70 bps. The 42 bps option applies 70% to the 60 bps default loss. 112 bps applies 70% to the full 160 bps. 100 bps treats the whole remainder as illiquidity.
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