FRM Part II · FRM Exam Part II · Estimating Default Probabilities
A risk manager estimates default probabilities from bond prices and also from historical data. She notes that if the recovery rate assumed in the bond-implied calculation is increased while the spread is held constant, what happens to the implied default probability?
The implied default probability increases. With the spread fixed, the spread is roughly default intensity times loss given default, so a higher recovery rate lowers loss given default and requires a higher default intensity to justify the same observed spread.
- AIt decreases
- BIt stays unchanged
- CIt increasesCorrect
- DIt becomes negative
Explanation
Spread is approximately hazard rate times (1 - R). With the spread fixed, a higher R shrinks the loss given default, so the hazard rate must rise to explain the same spread. A decrease would result only from a lower recovery assumption.
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.
More Estimating Default Probabilities questions
- A bank's risk committee debates whether to rely on through-the-cycle agency ratings or point-in-time internal ratings for monitoring its loa…
- A credit analyst estimates default probabilities from CDS spreads, and compares them with historical default probabilities for the same rati…
- A bank calibrates the Merton model to a firm and obtains a risk-neutral default probability. It then compares this with the historical (real…
- An analyst uses the approximation that the credit spread equals the hazard rate times (1 - recovery rate). A five-year bond trades at a spre…
- A one-year zero-coupon corporate bond yields 6.00% and the comparable risk-free zero yields 4.00% (both annually compounded). Recovery rate …
- A one-year zero-coupon corporate bond yields 6.0% and a comparable one-year risk-free zero yields 4.0% (both annual compounding). The recove…