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IAI Actuarial Core Principles · Economic Modelling · Simple models for credit risk

Under a reduced form model with zero recovery, a risky zero-coupon bond has continuously compounded yield 7.5% and the equivalent risk-free zero has yield 6.0% for the same term. What is the implied constant risk-neutral hazard rate?

The implied hazard rate is 1.5% per year. With zero recovery and continuous compounding, the credit spread equals the hazard rate, so subtract the risk-free yield of 6.0% from the risky yield of 7.5%.

  1. A1.5% per yearCorrect
  2. B13.5% per year
  3. C0.75% per year
  4. D1.25% per year
  5. 6.75% per year

Explanation

Risky yield equals risk-free rate plus hazard rate when recovery is zero, so λ = 7.5% - 6.0% = 1.5%. Option 1 adds the yields instead of subtracting them.

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