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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

During a market-wide credit stress, an issuer's credit spread widens sharply, but its credit rating and agency-estimated one-year default probability are unchanged. Which interpretation is most consistent with the spread widening?

The widening most likely reflects a higher market price of credit risk and lower liquidity, which raise risk-neutral default probability even though the real-world estimate is unchanged. Spreads include risk premia beyond expected loss, so they can move independently of ratings-based default probabilities.

  1. AReal-world default probability must have risen by exactly the spread change
  2. BRecovery rates must have risen
  3. CThe market price of credit risk and liquidity premia likely increased, raising risk-neutral default probability without a corresponding change in real-world probabilityCorrect
  4. DThe bond has been upgraded by the market

Explanation

Spread changes can reflect higher risk aversion and reduced liquidity, which increase the premium over expected loss. Thus the risk-neutral probability can rise while the historical or rating-based probability stays stable. Higher recovery would narrow, not widen, spreads.

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