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FRM Part II · FRM Exam Part II · Country Risk: Determinants, Measures, and Implications

A risk manager uses the approximation that the CDS spread equals the annual default probability multiplied by loss given default. A sovereign's 5-year CDS spread is 300 bps and the assumed recovery rate is 40%. What is the implied annual risk-neutral default probability?

The implied annual risk-neutral default probability is 5.0%. Loss given default is 60% (one minus the 40% recovery), and the CDS spread of 3.00% divided by 0.60 gives 5.0%. Dividing by the recovery rate instead would wrongly give 7.5%.

  1. A5.0%Correct
  2. B1.2%
  3. C7.5%
  4. D3.0%

Explanation

LGD = 1 - 40% = 60%. Spread = PD x LGD, so PD = 3.00% / 0.60 = 5.0%. Using 40% as the divisor gives 7.5%, a mistake of using recovery instead of loss. Multiplying 3% by 0.4 gives 1.2%, and ignoring recovery gives 3.0%.

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