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FRM Part II · FRM Exam Part II · Credit Derivatives

A risk analyst uses the credit triangle approximation to estimate the fair CDS spread on a reference entity. The annual hazard rate is 2.5% and the expected recovery rate is 40%. Which spread is closest to the approximate fair CDS spread?

The approximate fair spread is 150 basis points. The credit triangle sets the spread equal to the hazard rate times loss given default, so 2.5% multiplied by (1 minus 40% recovery) equals 1.5%.

  1. A100 basis points
  2. B150 basis pointsCorrect
  3. C250 basis points
  4. D60 basis points

Explanation

The credit triangle gives spread ≈ hazard rate × (1 − recovery) = 2.5% × 0.60 = 1.50%, or 150 bp. Using 2.5% × 0.40 = 100 bp mistakenly multiplies by the recovery rate rather than loss given default. 250 bp ignores recovery altogether.

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