FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk
A one-year zero-coupon bond issued by Alder Corp is priced to yield 6.00% (annual compounding), while the risk-free one-year rate is 4.00%. Assume the recovery rate is 40% of face value paid at maturity. Using the approximation that the risk-neutral default probability equals the spread divided by loss given default, what is the approximate one-year risk-neutral default probability?
The risk-neutral default probability is approximately the 2% spread divided by the 60% loss given default, which equals 3.33%. Dividing by recovery of 40% instead, or using the spread directly, ignores that only the loss portion drives the spread.
- A2.00%
- B3.33%Correct
- C5.00%
- D8.33%
Explanation
Spread = 6% - 4% = 2%. LGD = 1 - 0.40 = 60%. PD ≈ 2%/60% = 3.33%. Using the spread alone gives 2.00%, which ignores recovery; dividing by the recovery rate gives 5.00%.
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