FRM Part II · FRM Exam Part II · Derivatives
A CDS on a reference entity has a spread of 150 bp. Assuming a recovery rate of 40% and a constant hazard rate, what is the approximate annual risk-neutral default probability implied by the spread?
The implied annual default probability is about 2.5 percent. Using the credit triangle, the spread of 1.5 percent is divided by loss given default of 60 percent, which is one minus the 40 percent recovery rate.
- A1.50%
- B2.50%Correct
- C0.90%
- D3.75%
Explanation
The credit triangle gives hazard rate approx spread/(1 - recovery) = 1.50%/0.60 = 2.50%. Using the spread directly (1.50%) ignores recovery. 0.90% multiplies by 0.60 instead of dividing. 3.75% divides by the recovery rate 0.40.
Did you get it right without looking?
One question tells you little. A timed set on Derivatives shows your real accuracy, how long you take and where you lose marks.
More Derivatives questions
- A bank uses the Basel standardised CVA approach and a risk manager observes that a portfolio of long-dated swaps with a lower-rated counterp…
- A bank holds an uncollateralized interest rate swap with a corporate client. The swap currently has a mark-to-market value of -USD 3 million…
- A bank has an unilateral CVA on a swap with a counterparty with a loss given default of 60%. Over three annual periods, the discounted expec…
- A bank has a put option on its counterparty's own shares, bought from that counterparty. Compared with a put on an unrelated stock bought fr…
- A bank trades a cross-currency swap with a sovereign-linked entity in an emerging market, where the bank receives the local currency and pay…
- A bank that is a clearing member of a central counterparty (CCP) novates a bilateral interest rate swap to the CCP. Which statement best des…