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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A bond trades at a credit spread of 150 basis points over the risk-free rate. Assuming a recovery rate of 40% and using the credit triangle approximation, what is the implied annual hazard rate?

The credit triangle gives spread = hazard rate x loss given default. With a 150 bp spread and 60% loss given default, hazard = 1.50% / 0.60 = 2.50% per year. Using the spread directly ignores recovery, which would understate the hazard rate.

  1. A0.90%
  2. B2.50%Correct
  3. C3.75%
  4. D1.50%

Explanation

Credit triangle: spread = hazard x (1 - recovery), so hazard = 1.50% / 0.60 = 2.50%. Using 1.50% ignores recovery; 0.90% multiplies by (1-R) instead of dividing; 3.75% divides by the recovery rate of 0.40.

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