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David, Hope you don't mind if If ask some specific questions (from previous FRM exams) (As you mentioned, some of the questions are quite weird to say the least).

The yield on a zero-coupon Treasury bond with a one-year maturity is currently 6% per annum. The Treasury zero-coupon yield curve is assumed to be flat. The spread over Treasuries for an AA-rated corporate bond with a maturity of three years is 70 basis points. What is the expected of loss from default as a percentage of the non-default value for the corporate bond?

a. 1.278

b. 1.763

c. 2.078

d. 2.215

The Answer is supposed to be C (2.078)

PV (spread) - exp(-0.007) X 3 = .97219. The expected loss is 1- PV(spread) = .02078

What is the theory behind this? - the same as what Saunders gives as p= probability of payment = (1+i)/(1+k), and the probability of default as 1-p. except that it is compounded continously (CC) here and for three years.

But expected loss can't be equated as probability of default!!!. This is weird or am I confused?

I have also noticed that FRM questions liberally and freely assume CC with out mentioning it. If we solve the above using the (1+i/1+k) approach, we get answers close by but not the exact answer, which leaves us more confused than before

Thanks as always

J

The yield on a zero-coupon Treasury bond with a one-year maturity is currently 6% per annum. The Treasury zero-coupon yield curve is assumed to be flat. The spread over Treasuries for an AA-rated corporate bond with a maturity of three years is 70 basis points. What is the expected of loss from default as a percentage of the non-default value for the corporate bond?

a. 1.278

b. 1.763

c. 2.078

d. 2.215

The Answer is supposed to be C (2.078)

PV (spread) - exp(-0.007) X 3 = .97219. The expected loss is 1- PV(spread) = .02078

What is the theory behind this? - the same as what Saunders gives as p= probability of payment = (1+i)/(1+k), and the probability of default as 1-p. except that it is compounded continously (CC) here and for three years.

But expected loss can't be equated as probability of default!!!. This is weird or am I confused?

I have also noticed that FRM questions liberally and freely assume CC with out mentioning it. If we solve the above using the (1+i/1+k) approach, we get answers close by but not the exact answer, which leaves us more confused than before

Thanks as always

J

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