FRM Part II · FRM Exam Part II · Credit Derivatives
A risk analyst estimates that a reference entity has a constant annual hazard rate of 2% and an expected recovery rate of 40%. Using the credit triangle approximation, what is the approximate fair annual CDS spread?
The approximate fair spread is 120 basis points. The credit triangle sets the spread equal to the hazard rate multiplied by loss given default, so 2% times (1 minus 40% recovery) equals 1.2%. Ignoring recovery would overstate the spread at 200 basis points.
- A120 basis pointsCorrect
- B200 basis points
- C80 basis points
- D240 basis points
Explanation
The credit triangle gives spread ≈ hazard rate × (1 − recovery) = 2% × 0.60 = 1.2%, or 120 bp. Using 200 bp ignores recovery and treats the loss as the full notional. Using 80 bp wrongly multiplies by the recovery rate instead of the loss given default.
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