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

A risk manager notes that, during a market-wide credit crunch, the spread-implied default probabilities of investment-grade issuers rose sharply while realized default rates stayed low. Which is the most plausible interpretation?

The jump most likely reflects greater risk aversion and liquidity premia embedded in spreads. Risk-neutral probabilities include these premia, so the gap versus real-world probabilities widened even though realized defaults stayed low.

  1. ARecovery rates fell to zero, so risk-neutral probabilities mechanically rose
  2. BReal-world default probabilities necessarily rose by the same factor
  3. CThe rise mainly reflected higher risk aversion and liquidity premia, increasing the gap between risk-neutral and real-world probabilitiesCorrect
  4. DHistorical default data became invalid because bonds were repriced

Explanation

Risk-neutral probabilities include compensation for systematic risk and liquidity. In a crunch, risk aversion and illiquidity rise, widening spreads without a matching change in actual defaults. The claim that real-world probabilities rose equally conflicts with the low realized defaults.

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