FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms
A CDS on a reference entity has a quoted spread of 240 basis points. The recovery rate is assumed to be 40%. Using the approximation that spread equals annual hazard rate times (1 - recovery), what is the implied annual default probability (hazard rate)?
The implied annual default probability is the spread divided by loss given default: 2.40% divided by (1 minus 40%) equals 4.00%. Dividing by the recovery rate instead would give 6%, and ignoring recovery would give 2.4%.
- A1.44%
- B2.40%
- C4.00%Correct
- D6.00%
Explanation
Hazard rate = spread / (1 - R) = 2.40% / 0.60 = 4.00%. Option B ignores recovery. Option A multiplies spread by 0.6 (wrong operation). Option D divides by 0.4, using the recovery rate instead of the loss rate.
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