Credit Risk Management Practice Exam

How does the shape of the spread curve affect the default distribution?

1. Only downward curves lead to increased defaults

2. It is unaffected by the spread curve shape

3. An upward curve leads to a stepper cumulative default distribution

4. A downward curve results in steeper risk distribution

The correct answer is: An upward curve leads to a stepper cumulative default distribution

The shape of the spread curve significantly impacts the default distribution by indicating the market's perception of credit risk across different maturities. An upward-sloping spread curve generally means that investors require higher yields for taking on the risk of longer maturities, reflecting increased uncertainty and potential for default over an extended time horizon. This relationship leads to a steeper cumulative default distribution, as the probability of default rises more sharply at the longer end of the maturity spectrum. The upward trajectory highlights that investors expect greater defaults over time, which influences their risk assessment and decision-making. In contrast, other choices do not account for the nuanced relationship between spread curve shape and default risk. For instance, the implication that only downward curves result in increased defaults overlooks the higher-risk perception associated with upward curves. Saying the spread curve shape is unaffected fails to recognize how it conveys market sentiment about credit risk over time. Lastly, while a downward curve may suggest lower risk perception, it does not inherently result in a steeper risk distribution when compared to an upward curve. Thus, the effect of the spread curve's shape is crucial in understanding credit risk and default distributions, making the choice regarding the upward curve's relationship with the cumulative default distribution the most accurate statement.