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

A credit risk officer notes that historical average default rates by rating are being used to set real-world default probabilities, while bond-implied default probabilities are much higher. Which explanation is most consistent with this observed gap?

Bond-implied default probabilities are risk-neutral and include compensation for bearing systematic default risk, plus liquidity and tax effects in spreads, so they are higher than real-world default probabilities estimated from historical default experience.

  1. ABond yield spreads include compensation for risk premia, liquidity and taxes, so risk-neutral default probabilities exceed real-world historical probabilitiesCorrect
  2. BHistorical default rates are always overstated because withdrawn ratings are counted as defaults
  3. CBond-implied default probabilities are calculated using the real-world recovery rate only, so they must equal historical rates
  4. DRating agencies assign ratings solely from bond spreads, so the two measures must differ randomly

Explanation

Spread-implied (risk-neutral) default probabilities embed risk premia for default correlation and systematic risk, plus liquidity and tax effects, so they exceed historical real-world estimates. The other statements are not true.

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