Lecture 8: Estimating Default Probabilities (PD)

Question 1

Under the IRB approach, default probabilities (PD) are estimated by?
A) the bank
B) Basel committee

Answer 1

A) the bank

Question 2

Under the Foundation IRB approach, LGD, EAD and M (MA) are estimated by?
A) the bank
B) Basel committee

Answer 2

B) Basel committee

Question 3

Under the Advanced IRB approach, LGD, EAD and M (MA) are estimated by?
A) the bank
B) Basel committee

Answer 3

A) the bank

Question 4

The In-year default probabilities tend to increase with time for high-rating categories.
TRUE/FALSE

Answer 4

TRUE
There is a higher risk that the given high-rating company will be in a worse economic state in the long term

Question 5

The In-year default probabilities tend to decrease with time for low-rating categories.
TRUE/FALSE

Answer 5

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

Question 6

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

Answer 6

B) Conditional probability of default

Question 7

The conditional probability of default is calculated as the in-year default probability divided by the survival probability.
TRUE/ FALSE

Answer 7

TRUE

Question 8

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

Answer 8

In case of default, lenders (investors) do not lose everything. The pay-out from a default is referred to as the RECOVERY RATE

Question 9

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

Answer 9

A) Credit default spread

Question 10

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

Answer 10

In a credit default swap (CDS), the company that the CDS buyer wants to buy insurance against is referred to as (C) REFERENCE ENTITY

Question 11

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

Answer 11

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

Question 12

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

Answer 12

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

Question 13

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

Answer 13

TRUE

Question 14

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

Answer 14

TRUE

Question 15

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

Answer 15

B) CDS spread
D) Bond yield spread

Question 16

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

Answer 16

TRUE

Question 17

The CDS spread and the bond yield spread tends to be approximately equal
TRUE/FALSE

Answer 17

TRUE
If the CDS spread is lower than bond spread, there is an arbitrage opportunity

Question 18

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

Answer 18

TRUE

Question 19

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

Answer 19

All are correct

Question 20

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

Answer 20

Corporate bonds are relatively illiquid, which gives a premium in excess for the premium for credit risk

Question 21

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

Answer 21

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

Question 22

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

Answer 22

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