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

A risk analyst observes that the credit spread on a corporate bond implies a higher annual default probability than the historical default frequency for issuers with the same rating. Which statement best explains this gap?

Spread-implied default probabilities exceed historical ones because spreads include compensation for risk aversion, liquidity and tax effects in addition to expected loss. Risk-neutral probabilities are therefore typically higher than real-world probabilities, and the gap is not a data error.

  1. AHistorical default rates are always overstated because of survivorship in rating data
  2. BImplied default probabilities embed risk premia and liquidity or tax effects, so they exceed real-world probabilitiesCorrect
  3. CCredit spreads reflect only expected loss, so the difference must be a data error
  4. DReal-world default probabilities are computed under the risk-neutral measure and are therefore higher

Explanation

Spreads compensate investors for expected loss plus a premium for default risk uncertainty (systematic risk) and often liquidity and tax effects. Risk-neutral probabilities extracted from spreads therefore normally exceed real-world (historical) probabilities. Saying spreads reflect only expected loss ignores these premia.

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