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

A risk analyst at a bank observes a 5-year CDS spread of 240 basis points on a corporate reference entity. Assuming a recovery rate of 40%, which approximation gives the average annual hazard rate (default intensity) over the five years?

The average hazard rate is about 4.00% per year. The credit triangle says the CDS spread equals the hazard rate times loss given default, so dividing 2.40% by one minus the 40% recovery rate (0.60) gives 4.00%.

  1. A0.0240 / 0.40 = 6.00% per year
  2. B0.0240 x (1 - 0.40) = 1.44% per year
  3. C0.0240 / (1 - 0.40) = 4.00% per yearCorrect
  4. D0.0240 x 0.40 = 0.96% per year

Explanation

The credit triangle gives spread = hazard rate x (1 - recovery), so hazard = 0.0240 / 0.60 = 4.00%. Dividing by the recovery rate (6.00%) uses the wrong base; multiplying by (1 - R) gives 1.44% and inverts the relationship.

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