FRM Part I · FRM Exam Part I · Country Risk: Determinants, Measures, and Implications
A sovereign CDS has a spread of 300 bp. Assuming a recovery rate of 40% and using the simple approximation that spread equals annual default probability times loss given default, what is the implied annual risk-neutral probability of default?
The implied annual default probability is 5.00%. With a 40% recovery rate, loss given default is 60%, so dividing the 3.00% CDS spread by 0.60 gives the risk-neutral default probability of 5.00% per year.
- A1.20%
- B3.00%
- C5.00%Correct
- D7.50%
Explanation
Spread = PD x (1 - R). LGD = 60%. PD = 3.00% / 0.60 = 5.00%. Using 3.00% x 0.40 = 1.20% is the wrong-base error, and 3.00%/0.40 = 7.50% uses recovery instead of loss.
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