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

An analyst compares the bond yield spread over the risk-free rate with the CDS spread for the same reference entity and maturity. The 5-year bond yields 6.30% when the risk-free benchmark rate is 4.00%, while the 5-year CDS spread is 190 bps. Which statement best describes the situation and the implied default-probability relationship?

The basis is negative 40 bps: the CDS spread of 190 bps is below the bond spread of 230 bps. With equal recovery assumptions, the bond market is pricing a higher default probability than the CDS market.

  1. AThe CDS-bond basis is negative 40 bps; the bond market implies a higher default probability than the CDS market, assuming consistent recoveryCorrect
  2. BThe CDS-bond basis is positive 40 bps; the CDS market implies a higher default probability than the bond market
  3. CThe CDS-bond basis is zero because the two spreads must always be equal
  4. DThe basis is negative 230 bps because the bond spread is measured against the CDS

Explanation

Bond spread = 6.30% − 4.00% = 230 bps. Basis = CDS spread − bond spread = 190 − 230 = −40 bps. A larger bond spread, with the same recovery, implies higher hazard rate in the bond market. The positive-basis option reverses the sign, and the basis is not forced to zero in practice.

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