Lecture 8: Estimating Default Probabilities (PD) Flashcards
Under the IRB approach, default probabilities (PD) are estimated by?
A) the bank
B) Basel committee
A) the bank
Under the Foundation IRB approach, LGD, EAD and M (MA) are estimated by?
A) the bank
B) Basel committee
B) Basel committee
Under the Advanced IRB approach, LGD, EAD and M (MA) are estimated by?
A) the bank
B) Basel committee
A) the bank
The In-year default probabilities tend to increase with time for high-rating categories.
TRUE/FALSE
TRUE
There is a higher risk that the given high-rating company will be in a worse economic state in the long term
The In-year default probabilities tend to decrease with time for low-rating categories.
TRUE/FALSE
TRUE
If they survive in the first (1-2) years, it is a good signal for continued survival - lower categories either default quickly or improve their credit standing
The probability of defaulting given survival up to a given point in time is termed ____ ____
A) Survival probability
B) Conditional probability of default
C) Default probability
B) Conditional probability of default
The conditional probability of default is calculated as the in-year default probability divided by the survival probability.
TRUE/ FALSE
TRUE
In case of default, lenders (investors) do not lose everything. The pay-out from a default is referred to as the ____ ____.
A) Hazard rate of default intensity
B) Collateral
C) Recovery rate
In case of default, lenders (investors) do not lose everything. The pay-out from a default is referred to as the RECOVERY RATE
A swap agreement in which the seller of the agreement will compensate the buyer in the even of a default by a particular company or country. I.e., the buyer will be compensated if the company/country insured against defaults.
Such agreement is termed____
A) Credit default spread
B) Credit default swap
C) Credit default principal
A) Credit default spread
In a credit default swap (CDS), the company that the CDS buyer wants to buy insurance against is referred to as ______
A) Central clearing party
B) Notional principal
C) Reference entity
In a credit default swap (CDS), the company that the CDS buyer wants to buy insurance against is referred to as (C) REFERENCE ENTITY
In a credit default swap (CDS), the total amount (premium) that the buyer pays per year to the seller until the CDS expires of default of the reference entity occurs is referred to as _____
A) Notional principal
B) CDS spread
C) Reinsurance premium
In a credit default swap (CDS), the total amount (premium) that the buyer pays per year to the seller until the CDS expires of default of the reference entity occurs is referred to as (B) CDS SPREAD
In a CDS, the total face value of the bonds that can be sold in case of a credit event (default) is referred to as ____
A) Notional principal
B) CDS spread
C) Reinsurance premium
In a CDS, the total face value of the bonds that can be sold in case of a credit event (default) is referred to as (A) NOTIONAL PRINCIPAL
In a CDS, if the reference entity does not default, the protection seller will simply receive the quarterly credit spread payments from the CDS buyer.
But if a default happens, the protection seller must pay the buyer the principal of the bond (the value of the protected bond).
TRUE/ FALSE
TRUE
The credit spread is the payment paid from the protection buyer to the protection seller for the default protection (CDS) – this the extra rate of interest per annum required by investors for bearing a particular credit risk
TRUE/ FALSE
TRUE
There are two examples of credit spreads used in CDS agreements. Which?
A) Maturity spread
B) CDS spread
C) LIBOR spread
D) Bond yield spread
B) CDS spread
D) Bond yield spread
The bond yield spread used in a CDS is the amount by which the yield on a corporate bond exceeds the yield on a similar risk-free bond (e.g., treasury bond/LIBOR/ overnight rates)
TRUE/ FALSE
TRUE
The CDS spread and the bond yield spread tends to be approximately equal
TRUE/FALSE
TRUE
If the CDS spread is lower than bond spread, there is an arbitrage opportunity
If CDS spread < bond yield spread: the investor can earn more than the risk-free rate by buying the corporate bond and buying protection
If CDS spread > bond yield spread: the investor can borrow at less than the risk-free rate by shorting the corporate bond and selling protection
TRUE/ FALSE
TRUE
Risk-neutral PD is higher than real-world PD: I.e., the yield spread on corporate bonds compensate for more than just the default probability, (expected excess return in table 19.6 have positive values). Why? Select all correct:
A) Corporate bonds are illiquid
B) Default probabilities of bond traders are somewhat subjective
C) Positive default correlation for different bonds
All are correct
One of the reasons why risk-neutral PD is higher than real-world PD (i.e. the yield spread on corporate bonds compensate for more than just the default probability) is corporate bond illiquidity.
Explain briefly how
Corporate bonds are relatively illiquid, which gives a premium in excess for the premium for credit risk
One of the reasons why risk-neutral PD is higher than real-world PD (i.e. the yield spread on corporate bonds compensate for more than just the default probability) is subjectivity in bond default probability estimation.
Explain briefly how
The subjective default probabilities of bond traders may be much higher than the estimates from historical data (Moody’s) – there is an tendency to expect the worse, and therefore assign a higher probability of default when pricing assets compared to what is actually happening in real world
One of the reasons why risk-neutral PD is higher than real-world PD (i.e. the yield spread on corporate bonds compensate for more than just the default probability) is positive default correlation of different bonds.
Explain briefly how
Bonds do not default independently of each other (e.g., in times of recession). This leads to systematic risk that cannot be diversified away – which gives an additional premium
