FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk
A one-year zero-coupon corporate bond yields 6.00% (continuous compounding) while a comparable risk-free zero yields 4.00%. Assuming a 40% recovery rate, what is the approximate risk-neutral one-year default probability using the formula spread ≈ PD × (1 − R)?
The approximate risk-neutral default probability is 3.33%. The 2% spread equals default probability times loss given default, and with a 40% recovery the loss given default is 60%, so 2% divided by 0.60 gives about 3.33%.
- A2.00%
- B3.33%Correct
- C5.00%
- D1.20%
Explanation
Spread = 6% − 4% = 2%. Loss given default = 1 − 0.40 = 0.60. PD ≈ 2%/0.60 = 3.33%. Using 2% directly ignores recovery (2.00%); dividing by 0.4 gives 5.00%, which uses recovery instead of LGD.
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