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FRM Part I · FRM Exam Part I · Corporate Bonds

Which statement about credit spreads on corporate bonds is correct?

Credit spreads compensate for expected default loss plus a premium for bearing credit risk and other factors, so they generally exceed expected loss alone. They do not equal default probability, widen in downturns, and fall when recovery rates rise.

  1. AThe spread compensates investors for expected default loss and for bearing credit risk, so it generally exceeds expected loss aloneCorrect
  2. BA bond's credit spread equals its probability of default exactly
  3. CSpreads typically narrow when economic conditions deteriorate
  4. DA higher recovery rate, with other inputs fixed, implies a larger spread

Explanation

Spreads reflect expected loss (PD x LGD) plus a risk premium for uncertainty, liquidity and similar factors. Spread is not PD, because recovery matters. Spreads widen in downturns, and higher recovery lowers expected loss and thus the spread.

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