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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A risk manager notes that a bond's spread widened sharply while its estimated hazard rate, calibrated with a fixed 40% recovery assumption, rose by less than the spread change implied. Which interpretation is most consistent with reduced-form modeling?

Spreads in reduced-form calibrations combine default intensity, loss given default, and risk and liquidity premia. A spread move larger than the hazard change implies may therefore reflect lower expected recovery or higher premia rather than only a higher default intensity.

  1. AThe hazard rate must be falling, since recovery is fixed
  2. BSpreads reflect only expected loss, so liquidity premia cannot cause such a gap
  3. CPart of the spread widening may reflect a lower expected recovery or risk and liquidity premia, not only higher default intensityCorrect
  4. DThe firm's asset value must have crossed a default barrier

Explanation

Spread ≈ λ(1−R) plus risk and liquidity premia, so a spread move can come from lower recovery, higher risk premia or liquidity, not only λ. Assuming spreads reflect only expected loss is wrong, and the barrier idea is structural.

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