FRM Part I · FRM Exam Part I · Measuring Credit Risk
A one-year zero-coupon bond issued by Corvex Ltd yields 6.00% (annual compounding), while a risk-free one-year zero yields 4.00%. Assuming a recovery rate of 40% of face value, and using the approximation that credit spread ≈ PD × LGD, what is the implied one-year risk-neutral default probability?
The implied risk-neutral default probability is about 3.33%. The spread of 2% equals PD times loss given default, and LGD is 60% (one minus 40% recovery), so PD is 2% divided by 0.60, giving roughly 3.33%.
- A3.33%Correct
- B2.00%
- C5.00%
- D8.00%
Explanation
Spread = 6% - 4% = 2%. LGD = 1 - 40% = 60%. PD ≈ 2% / 0.60 = 3.33%. Option 2.00% ignores LGD (treats spread as PD); 5.00% divides by recovery rate (0.40); 8.00% multiplies the spread by 4 and is unrelated to any step.
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