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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A credit analyst at a bank prices a five-year corporate bond using default probabilities backed out of observed bond yield spreads. She then compares them with default probabilities computed from historical rating-agency default experience for the same rating class. Which statement best describes the typical relationship she will observe?

Risk-neutral default probabilities implied by bond spreads are typically higher than real-world historical probabilities. Spreads compensate investors for expected losses plus risk premia, liquidity and other factors, so the implied hazard rate overstates actual default likelihood observed in historical data.

  1. ASpread-implied (risk-neutral) default probabilities are generally higher than historical (real-world) default probabilitiesCorrect
  2. BSpread-implied default probabilities are generally lower than historical default probabilities
  3. CThe two measures are equal in efficient markets because spreads reflect only expected losses
  4. DThe two measures differ only because of the recovery rate assumption, with no role for risk premia

Explanation

Bond spreads compensate investors not only for expected default losses but also for risk premia such as systematic risk, liquidity and tax effects. Backing out default intensities from spreads therefore gives risk-neutral probabilities that exceed historical real-world ones. Option C is wrong because spreads include more than expected loss.

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