Skip to content

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

Which statement about credit spreads on corporate bonds is correct under the simple models studied for credit risk?

Higher expected recovery reduces the credit spread. The spread is roughly the hazard rate times loss given default, which is one minus recovery, so greater recovery means smaller loss and smaller spread, other things equal.

  1. AThe spread compensates only for expected default loss, never for risk aversion
  2. BThe spread is always exactly equal to the real-world default probability
  3. CHigher expected recovery, other things equal, reduces the spreadCorrect
  4. DThe spread falls as the hazard rate rises
  5. The spread on a zero-coupon bond is independent of recovery

Explanation

Expected loss given default is (1 - recovery), so greater recovery lowers the loss and the spread, approximately λ(1-R). The spread rises with hazard rate, and it also includes a risk premium so it exceeds real-world expected loss.

Did you get it right without looking?

One question tells you little. A timed set on Simple models for credit risk shows your real accuracy, how long you take and where you lose marks.

Practise Simple models for credit riskFree diagnostic mock

More Simple models for credit risk questions