FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk
A one-year zero-coupon bond issued by a firm trades at a continuously compounded yield 3.00% above the risk-free rate. Assuming a constant hazard rate and a recovery rate of 40% of face value (recovery of treasury value assumption not needed; use the approximation spread ≈ hazard × (1 − recovery)), what is the approximate annual hazard rate?
The approximate hazard rate is 5.00%. The spread equals the hazard rate times loss given default, which is 60% with 40% recovery, so dividing the 3.00% spread by 0.60 gives 5.00% per year.
- A1.20%
- B1.80%
- C5.00%Correct
- D7.50%
Explanation
Spread = λ(1 − R), so λ = 3.00% / (1 − 0.40) = 3.00% / 0.60 = 5.00%. Check: 5.00% × 0.60 = 3.00%. The 1.80% result wrongly multiplies the spread by 0.60, and 7.50% divides by 0.40 (using the recovery rate rather than loss given default).
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