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FRM Part I · FRM Exam Part I · Measuring Credit Risk

A one-year zero-coupon bond issued by Alder Corp has a continuously compounded yield of 6.00%, while the risk-free one-year continuously compounded rate is 4.50%. Assume a constant hazard rate and a recovery rate of 40% of face value. Using the approximation that the credit spread equals hazard rate times (1 - recovery rate), what is the implied annual hazard rate?

The implied hazard rate is 2.50%. The credit spread is 1.50% (6.00% minus 4.50%), and under the reduced-form approximation spread equals hazard rate times loss given default of 60%, so the hazard rate is 1.50% divided by 0.60.

  1. A1.50%
  2. B2.50%Correct
  3. C3.75%
  4. D0.90%

Explanation

Spread = 6.00% - 4.50% = 1.50%. Hazard rate = spread / (1 - R) = 1.50% / 0.60 = 2.50%. Check: 2.50% x 0.60 = 1.50%. Using 1.50% directly ignores recovery; 3.75% divides by R (0.40); 0.90% multiplies spread by 0.60.

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