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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A credit portfolio manager compares a bond's risk-neutral default probability, derived from its spread, with the real-world probability used for expected loss. For which purpose should the risk-neutral probability be used?

Risk-neutral default probabilities should be used for valuing and hedging credit derivatives consistent with market prices. Real-world probabilities are the right input for forecasting defaults, expected loss provisioning and capital estimation, because those concern actual outcomes rather than prices.

  1. AEstimating the expected credit loss provision over the next year
  2. BCalculating the economic capital needed at a 99.9% confidence level from historical default data
  3. CValuing or hedging a credit derivative on the bond consistent with market pricesCorrect
  4. DForecasting the actual number of defaults in the portfolio next year

Explanation

Risk-neutral probabilities are calibrated to market prices and are appropriate for pricing and hedging, such as valuing a credit default swap. Real-world probabilities are used for scenario analysis, expected loss, capital and forecasting actual defaults.

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