CFA Level I · CFA Level I Exam · Credit Risk
A reduced-form model estimates a constant annual default intensity (hazard rate) of 2.0% and a loss given default of 60%. Using the approximation that expected loss equals intensity times loss given default, the credit spread is closest to:
The spread is about 1.2%. It equals the default intensity of 2.0% multiplied by the loss given default of 60%, giving the annual expected loss that compensates investors under a risk-neutral approximation.
- A0.8%
- B1.2%Correct
- C3.0%
Explanation
Spread ≈ hazard rate × LGD = 0.02 × 0.60 = 0.012, or 1.2%. The 0.8% figure results from using recovery of 40% instead of LGD. The 3.0% figure divides 2.0% by 0.6 3.33 style inversion or equivalent, which is wrong.
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