Skip to content

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

A risk manager compares default probabilities implied by bond spreads (risk-neutral) with those from historical rating-agency default experience (real-world) for BBB-rated issuers. Which statement best describes the typical finding and its main explanation?

Risk-neutral default probabilities from bond spreads are typically much higher than historical real-world ones. Spreads reward investors for bearing systematic default risk, illiquidity and tax disadvantages in addition to expected default losses, so they overstate the actual likelihood of default.

  1. ARisk-neutral probabilities are substantially higher, partly because spreads compensate for risk premia, liquidity and tax effects beyond expected default lossCorrect
  2. BReal-world probabilities are higher, because historical data include defaults that bond markets ignore
  3. CThe two are approximately equal, because bond prices fully reflect only expected default losses
  4. DRisk-neutral probabilities are lower, because investors are risk-seeking in credit markets

Explanation

Empirically, implied risk-neutral default intensities exceed historical ones, often by multiples, for investment-grade names. Spreads include compensation for systematic default risk, bond illiquidity and taxation, not only expected loss. Equality would require risk-neutral investors with no frictions.

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