Credit Risk Management Practice Exam

How can credit spread be represented?

1. By the difference in book values of two securities

2. By the difference in yields between a security and a reference security

3. By the average market return over a period

4. By the total income generated from bonds

The correct answer is: By the difference in yields between a security and a reference security

Credit spread represents the difference in yield between a security, typically a corporate bond, and a benchmark security, often a government bond of similar maturity. This difference is indicative of the additional risk investors bear when investing in the corporate bond over the safer government bond. The credit spread reflects the perceived credit risk associated with the issuer of the corporate bond; a wider spread suggests greater credit risk and vice versa. For instance, if a corporate bond has a yield of 8% and the corresponding government bond yields 3%, the credit spread would be 5%. This spread compensates investors for taking on the higher risk of default associated with the corporate issuer compared to the virtually risk-free government security. In contrast, the other options do not accurately represent credit spread. The difference in book values does not account for the market perception of risk but rather reflects accounting evaluations. The average market return over a period does not specifically pertain to the comparison between individual securities or their associated risks. Lastly, total income generated from bonds relates to cash flows rather than the relative risk assessed via credit spreads. Thus, the characterization of credit spread is best captured by the difference in yields between a security and a reference security.