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

A risk manager wants to use default probabilities for two purposes: (1) calculating a one-year credit VaR for a loan portfolio for economic capital, and (2) marking to market a credit default swap position held by the trading desk. Which choice of default probability is most appropriate?

Use real-world probabilities for credit VaR and economic capital, because these estimate actual potential future losses, and risk-neutral probabilities for marking a CDS, because valuation must be consistent with market prices that include risk premia.

  1. ARisk-neutral probabilities for both purposes
  2. BReal-world probabilities for both purposes
  3. CReal-world probabilities for (1) and risk-neutral probabilities for (2)Correct
  4. DRisk-neutral probabilities for (1) and real-world probabilities for (2)

Explanation

Scenario analysis of potential future losses, such as credit VaR and economic capital, needs the actual likelihood of default, so real-world probabilities apply. Valuing a CDS today requires consistency with market prices, which embed risk premia, so risk-neutral probabilities are used. The reverse assignment would misstate both loss estimates and prices.

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