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

A risk manager compares default probabilities implied by corporate bond spreads (risk-neutral) with historical default rates (real-world) for investment-grade issuers. Which statement best describes the typical finding and its most appropriate use?

Risk-neutral default probabilities from bond spreads are usually higher than historical ones because spreads include risk premia and liquidity effects. They suit pricing and valuation, but using them to forecast actual credit losses would overstate expected losses; historical probabilities fit real-world loss estimation.

  1. ARisk-neutral probabilities are typically higher than historical ones, so they are appropriate for pricing but would overstate expected credit losses in scenario analysis of real-world lossesCorrect
  2. BRisk-neutral probabilities are typically lower than historical ones, so they are appropriate for calculating regulatory capital
  3. CThe two are identical when recovery rates are correctly estimated, so either can be used for any purpose
  4. DHistorical probabilities are higher because bond spreads contain no default risk premium

Explanation

Spreads embed risk premia, liquidity and tax effects beyond expected loss, so implied probabilities exceed historical ones. They suit valuation of credit derivatives and CVA, while real-world probabilities suit loss forecasting and stress testing. The other options reverse or deny this relationship.

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