Skip to content

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

A risk manager compares 5-year default probabilities estimated from historical rating-agency data with those implied from CDS spreads and bond yields for the same BBB-rated issuers. The market-implied probabilities are consistently much higher. Which explanation is most consistent with the standard treatment of this finding?

Risk-neutral probabilities implied by CDS spreads and bond yields include risk premia and liquidity compensation, so they exceed real-world historical probabilities. Use risk-neutral estimates for valuing credit instruments and real-world estimates when assessing actual expected losses or scenario analysis.

  1. AMarket-implied probabilities are real-world estimates and agency data are risk-neutral, so the agency data are biased upward
  2. BRisk-neutral probabilities embed risk premia and liquidity effects, so they exceed real-world probabilities and suit valuation rather than scenario analysis of actual lossesCorrect
  3. CRecovery rates in CDS pricing are always set to zero, which mechanically inflates the implied probabilities
  4. DCDS-implied probabilities are calculated over a shorter horizon than historical probabilities, which accounts for the gap

Explanation

Market-implied (risk-neutral) default probabilities are higher than historical (real-world) ones because investors demand compensation for default risk correlation, bond/CDS liquidity and other premia. Risk-neutral values should be used for pricing and valuation, while real-world values suit estimating actual potential losses. The other options reverse the labels or invent mechanical causes.

Did you get it right without looking?

One question tells you little. A timed set on Estimating Default Probabilities shows your real accuracy, how long you take and where you lose marks.

Practise Estimating Default ProbabilitiesFree diagnostic mock

More Estimating Default Probabilities questions