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

Which of the following is a reason that bond-spread-implied default probabilities overstate real-world default probabilities, even after allowing for expected recovery?

Spread-implied probabilities exceed real-world ones partly because defaults are correlated with systematic market conditions, so investors require compensation for non-diversifiable risk. Spreads also reflect liquidity and tax effects, so they contain more than expected default loss.

  1. ADefaults are strongly correlated with systematic factors, so investors demand compensation for bearing this non-diversifiable riskCorrect
  2. BHistorical default data are always computed using risk-neutral valuation
  3. CCorporate bonds are more liquid than Treasury securities, which lowers the yield spread
  4. DRecovery rates are always zero in the event of default

Explanation

Default risk contains a systematic component that cannot be diversified, and bond returns are skewed, so investors require a risk premium. Together with lower liquidity and tax effects relative to Treasuries, this raises spreads. Option C is backwards because corporate bonds are generally less liquid than Treasuries.

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