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

A portfolio manager compares historical default rates with default probabilities implied by bond yields (risk-neutral) for the same rating class. Which observation is most consistent with empirical evidence?

Risk-neutral default probabilities implied by bond yields are typically higher than historical default probabilities. Spreads include compensation for systematic default risk, liquidity and other factors beyond expected default loss, so using them as real-world probabilities would overstate expected losses.

  1. ARisk-neutral default probabilities are typically higher than historical ones, reflecting risk premiums and other non-default components of spreads.Correct
  2. BRisk-neutral default probabilities are typically lower than historical ones because spreads exclude default risk.
  3. CThe two measures are equal in efficient markets.
  4. DHistorical default rates are higher for investment grade than for speculative grade.

Explanation

Spreads compensate for expected loss and also for risk premiums for default correlation, liquidity and taxes, so implied probabilities exceed historical ones. The other options contradict observed data or ordering by rating.

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