Skip to content

FRM Part II · FRM Exam Part II · Structured Credit Risk

A risk manager is valuing a senior CDO tranche using a risk-neutral approach. Compared with using real-world default probabilities, which feature of the risk-neutral approach explains why its implied tranche spread is higher?

Risk-neutral valuation uses default probabilities that are higher than real-world ones because they embed the risk premium investors demand for bearing systematic default risk. This lifts implied spreads, particularly for senior tranches exposed to market-wide credit stress.

  1. AIt assumes recoveries are zero in all scenarios
  2. BIt ignores the correlation among assets in the pool
  3. CIt uses default probabilities inflated to reflect the risk premium investors demand for bearing systematic default riskCorrect
  4. DIt discounts at the risk-free rate, so spreads become negative

Explanation

Risk-neutral default probabilities, implied from market spreads, exceed real-world ones because they embed compensation for systematic risk. The risk-neutral approach does not ignore correlation or set recoveries to zero. Discounting at the risk-free rate does not produce negative spreads.

Did you get it right without looking?

One question tells you little. A timed set on Structured Credit Risk shows your real accuracy, how long you take and where you lose marks.

Practise Structured Credit RiskFree diagnostic mock

More Structured Credit Risk questions