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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A portfolio manager uses risk-neutral default probabilities backed out of CDS spreads to estimate expected credit losses for provisioning on a held-to-maturity loan book. Which criticism is most appropriate?

Risk-neutral probabilities suit pricing and valuing credit instruments, but they embed risk premia and generally exceed real-world default likelihood. For estimating actual expected losses, such as provisions or stress scenarios, real-world probabilities should be used, so applying them directly would overstate losses.

  1. ARisk-neutral probabilities are lower than real-world ones, so provisions will be understated
  2. BRisk-neutral probabilities are suitable for pricing and valuation but typically overstate real-world expected losses, so they should not be used directly for estimating actual loss provisionsCorrect
  3. CCDS spreads contain no information about default likelihood
  4. DRisk-neutral probabilities cannot be computed when recovery is positive

Explanation

Risk-neutral probabilities are used for valuing instruments consistent with market prices, including risk premia. For scenario analysis or loss estimation in the real world, physical-measure probabilities are appropriate. The first option reverses the usual relationship.

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