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

A credit analyst notes that an issuer's bond spread widened by 100 basis points while the credit rating and the company's fundamentals are unchanged. Market-wide corporate bond liquidity has deteriorated sharply. What is the most appropriate conclusion about using the spread to infer default probability?

The implied default probability is probably overstated. Part of a spread widening during a liquidity squeeze is a liquidity premium, not a change in expected default, so dividing the whole increase by loss given default attributes non-credit compensation to default risk.

  1. AThe implied default probability is likely overstated, since part of the spread reflects a liquidity premium rather than default expectationsCorrect
  2. BThe implied default probability is understated, since illiquidity lowers bond yields
  3. CThe spread change is wholly attributable to higher recovery risk
  4. DThe spread is unaffected by liquidity, so the implied default probability rose by about 100 bp divided by LGD

Explanation

Bond spreads include non-default components such as liquidity premia. When liquidity worsens, investors demand higher yields even with unchanged credit quality, so attributing the entire widening to default intensity overstates default probability. Illiquidity raises, not lowers, required yields.

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