FRM Part II · FRM Exam Part II · Credit Derivatives
A one-year CDS on a reference entity has a constant annual hazard rate of 3% and an expected recovery rate of 40%. Using the approximation that the CDS spread equals hazard rate multiplied by (1 minus recovery), what is the approximate annual spread?
The approximate spread is 180 basis points. It equals the 3% hazard rate times the 60% loss given default (one minus 40% recovery), giving 1.8% per year. Ignoring recovery would overstate the spread at 300 basis points.
- A120 basis points
- B180 basis pointsCorrect
- C300 basis points
- D500 basis points
Explanation
Spread ≈ 0.03 × (1 − 0.40) = 0.03 × 0.60 = 0.018, i.e. 180 bp. Using 300 bp ignores recovery (loss given default). 120 bp wrongly multiplies by the recovery rate (0.03 × 0.40). 500 bp divides the hazard rate by the recovery-based fraction (0.03/0.6).
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