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

A risk analyst compares the default probability implied by a corporate bond's credit spread with the default probability estimated from historical rating-agency default data for the same rating. The implied figure is substantially higher. Which statement best explains the difference?

Risk-neutral default probabilities implied by spreads are usually higher than historical ones because spreads include compensation for systematic default risk, liquidity and tax effects in addition to expected default loss. Historical data reflects only real-world frequency, so the two measures naturally differ.

  1. AHistorical default data always overstates true default risk because of survivorship bias
  2. BThe credit spread compensates not only for expected default loss but also for risk premia such as default correlation, liquidity and tax effects, so the risk-neutral probability exceeds the real-world oneCorrect
  3. CThe implied probability is higher because bond prices ignore recovery rates
  4. DRisk-neutral probabilities are computed using the physical measure and are therefore larger

Explanation

Spreads embed compensation for bearing systematic default risk, liquidity and other factors beyond expected loss. Hence risk-neutral default probabilities typically exceed real-world (historical) ones. Recovery is incorporated in spread-based estimates, not ignored, and risk-neutral probabilities are not computed under the physical measure.

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