FRM Part II · FRM Exam Part II · Credit Derivatives
A five-year CDS is priced with a flat risk-neutral hazard rate. All else equal, the market's expected recovery rate assumption is raised from 30% to 50%, while the observed quoted spread stays unchanged at 180 bp. What is the effect on the implied hazard rate calibrated from that spread?
The implied hazard rate rises. With the spread fixed at 180 bp, a higher recovery rate lowers loss given default, so a larger default intensity is required to justify the same spread, roughly 3.6% instead of 2.57%.
- AThe implied hazard rate falls
- BThe implied hazard rate risesCorrect
- CThe implied hazard rate is unchanged
- DThe implied hazard rate becomes negative
Explanation
Spread ≈ hazard × (1 − R). With the spread fixed, a higher recovery lowers LGD, so hazard = spread/(1 − R) must rise: 1.8%/0.70 ≈ 2.57% versus 1.8%/0.50 = 3.6%. The hazard rate does not fall.
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