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

A credit analyst estimates default probabilities from CDS spreads, and compares them with historical default probabilities for the same rating class. Which conclusion is most consistent with the standard finding in the reading?

Risk-neutral default probabilities implied by CDS spreads are typically higher than historical real-world probabilities, because they embed a risk premium and other compensation. Risk-neutral values are used for pricing and valuation, while real-world estimates suit loss and scenario analysis.

  1. ARisk-neutral default probabilities from CDS spreads are typically higher than real-world historical default probabilities, because they include a risk premiumCorrect
  2. BRisk-neutral default probabilities are typically lower than historical ones, because markets are optimistic
  3. CThe two measures are equal when the recovery rate is estimated correctly
  4. DReal-world probabilities should be used to value CDS contracts and risk-neutral ones to compute economic capital

Explanation

Market-implied (risk-neutral) default probabilities exceed historical (real-world) ones because investors demand compensation for bearing default risk, and for liquidity and systematic risk. The reading advises risk-neutral for pricing and valuing, and real-world for scenario analysis such as potential losses. Option 4 reverses this use.

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