Skip to content

FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A one-year zero-coupon bond issued by Delta Corp yields 5.00% per year (continuous compounding) while the risk-free rate is 3.00% (continuous). Assuming a 40% recovery rate, the risk-neutral one-year default probability is closest to:

The risk-neutral default probability is about 3.3%. The 2% credit spread equals default probability times loss given default, which is 60% with a 40% recovery. Dividing 2% by 0.6 gives roughly 3.3%, so ignoring recovery would understate the probability.

  1. A2.0%
  2. B3.3%Correct
  3. C5.0%
  4. D8.0%

Explanation

Spread = 2% = PD x (1 - R), so PD ≈ 0.02/0.60 = 3.33%. Using the exact form: 1-year PV ratio exp(-0.02)=0.98020 = 1 - PD(0.6), giving PD = 3.30%. The 2.0% option ignores recovery by treating spread as PD.

Did you get it right without looking?

One question tells you little. A timed set on Estimating Default Probabilities shows your real accuracy, how long you take and where you lose marks.

Practise Estimating Default ProbabilitiesFree diagnostic mock

More Estimating Default Probabilities questions