FRM Part II · FRM Exam Part II · Derivatives
A five-year CDS on a reference entity has a quoted spread of 200 bps per year, paid annually. The risk-neutral annual default probability is assumed constant at 3.2%, and the recovery rate is 40%. Using the approximation spread ≈ hazard rate × (1 − recovery), the implied hazard rate is closest to:
The implied hazard rate is about 3.33%. Dividing the 2% spread by the loss given default of 60% (one minus 40% recovery) gives 3.33% a year, close to the assumed 3.2% default probability.
- A3.33%Correct
- B1.20%
- C2.00%
- D5.00%
Explanation
Hazard rate ≈ spread / (1 − R) = 2.00% / 0.60 = 3.33%. Option B multiplies by 0.6 instead of dividing. Option C ignores recovery. Option D divides by the recovery rate: 2%/0.4.
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