FRM Part II · FRM Exam Part II · Estimating Default Probabilities
A bond trades at a credit spread of 240 basis points over the risk-free rate. Assuming a recovery rate of 40% and using the approximation that the spread equals the hazard rate times (1 - recovery), what is the implied annual default intensity?
The implied default intensity is 4.00% per year. The spread of 2.40% compensates for expected loss given default, which is hazard rate times one minus recovery of 40%, so dividing 2.40% by 0.60 gives the 4.00% hazard rate.
- A1.00%
- B4.00%Correct
- C5.76%
- D6.00%
Explanation
Hazard rate = spread / (1 - R) = 2.40% / 0.60 = 4.00%. Using 2.40%/0.40 = 6.00% mistakenly divides by the recovery rate. Multiplying 2.40% by 0.60 gives 1.44%, and 2.40% x 2.4 = 5.76% is not a valid relation.
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