Credit Risk Management Practice Exam

In the context of credit risk, what do CDS spreads indicate?

1. The historical performance of a company

2. Market expectation of probability of default

3. Regulatory risk assessments

4. The company’s financial ratios

The correct answer is: Market expectation of probability of default

CDS spreads, or Credit Default Swap spreads, primarily reflect the market's expectations about the probability of default of a borrowing entity, such as a corporation or a government. When investors are willing to pay more for a CDS, it indicates they perceive a higher risk of default, thus leading to wider spreads. Conversely, narrower spreads suggest lower perceived risk. This makes CDS spreads a vital tool for investors to gauge the creditworthiness of an entity in real-time by assessing how much risk the market associates with it. While historical performance, regulatory assessments, and specific financial ratios can provide useful insights into a company's stability, they do not capture the prevailing market sentiment regarding credit risk as effectively as CDS spreads do. Therefore, the ability of CDS spreads to offer an up-to-date measure of expected default probability is why they are fundamentally linked to credit risk assessment.