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

A risk analyst at a bank observes that a 5-year CDS on Corporation Alpha trades at a spread of 240 basis points per year. Assuming a recovery rate of 40%, which is the approximate average annual hazard rate (risk-neutral default intensity) implied by the spread?

The implied hazard rate is about 4.00% per year. The CDS spread approximates hazard rate times loss given default, so dividing 2.40% by (1 − 40%) gives 4.00%. Simply using the spread ignores recovery, and dividing by the recovery rate overstates the intensity.

  1. A1.00%
  2. B4.00%Correct
  3. C6.00%
  4. D2.40%

Explanation

The approximation is spread ≈ hazard rate × (1 − recovery). So hazard rate = 2.40% / (1 − 0.40) = 4.00%. Using 2.40% ignores the recovery adjustment, and 1.00% is 2.40% × 0.40 (multiplying by recovery rather than dividing by loss given default). 6.00% would come from dividing by the recovery rate (2.4/0.4).

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