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P1.T1.604. Credit risk (Topic review)

Nicole Seaman

Director of FRM Operations
Staff member

604.1. A $1,000 face value corporate bond with ten years to maturity and a 3.0% annual coupon (i.e., assume annual compounding) has a current price of $918.89. If the market's recovery rate (ie, one minus loss given default) consensus estimate is 20.0% and the risk-free yield is flat at 1.0%, which is nearest to an APPROXIMATION of the bond's default probability?

a. 2.67%
b. 3.75%
c. 5.00%
d. Need more information

604.2. Consider the two yield curves below. The one-year risk-free rate is 1.0% and the two-year risk-free rate is 2.0%. For a given corporate bond, the one-year rate is 2.0% and the two-year rate is 4.0%:

If we assume annual compounding, the implied one-year forward risk-free rate is 3.010% = 1.02^2/1.01 - 1. We can similarly infer the implied one-year forward rate of the corporate bond. If we assume zero recovery and a basic no-arbitrage assumption given by (probability of repayment)*(1+risky rate) = (1+ risk-free rate), then which is nearest to the the implied conditional default probability in the second year?

a. 0.9%
b. 1.3%
c. 2.0%
d. 2.9%

604.3. Silvercore Financial Services purchases credit protection on an underlying bond issued by Lanehigh Corporation by purchasing a credit default swap (CDS). Each of the following is true about the CDS EXCEPT which is false?

a. Bankruptcy and failure to pay by Lanehigh are credit events
b. If the underlying bond is downgraded and the bond's price reacts by dropping, the mark-to-market value of the CDS will increase
c. The CDS generally provides a hedge against market risk as defined by a shift in risk-free rate curve; e.g., the theoretical spot rate for US Treasury securities
d. A credit agency downgrade of the bond is not a credit event; and a restructuring by Lanehigh may or may not be a credit event depending on the restructuring clause

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