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CMA Final · Risk Management in Banking and Insurance · Sovereign Risk and Insolvency Risk

Sovereign bond yield for a country is 9.5% and the risk-free yield of the benchmark is 6.0%. Using the credit spread approach with an assumed recovery rate of 40%, what is the approximate annual default probability implied by the market?

The implied default probability is about 5.83%. The credit spread is 3.5% (9.5% less 6.0%), and dividing it by the loss rate of 60% (one minus 40% recovery) gives 5.83%. Using the spread alone would ignore the recoveries.

  1. A5.83%Correct
  2. B3.50%
  3. C8.75%
  4. D2.10%

Explanation

Spread = 9.5% - 6.0% = 3.5%. Approximate PD = spread / (1 - recovery) = 3.5% / 0.60 = 5.83%. 3.50% ignores recovery. 2.10% multiplies the spread by 0.6 instead of dividing. 8.75% divides by 0.4, which uses the recovery rate instead of the loss rate.

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