Credit Risk Management Practice Exam

What does a risk-neutral default rate imply regarding credit spreads?

1. It is not affected by market trends

2. It can be inferred from credit spreads

3. It depends solely on historical defaults

4. It varies with economic cycles

The correct answer is: It can be inferred from credit spreads

A risk-neutral default rate refers to the likelihood of a borrower defaulting on its obligations as perceived by the market, assuming no risk aversion from investors. When examining the relationship between default rates and credit spreads, the risk-neutral default rate is a crucial component because credit spreads, which represent the yield difference between a risky bond and a risk-free bond, are fundamentally linked to the perceived default risk of the borrower. When market participants assess credit spreads, they incorporate their expectations of default into the pricing of credit risk. Therefore, the risk-neutral default rate can be derived from these spreads, as the spread compensates investors for the risk they are taking by holding a bond that carries the potential for default. A higher credit spread typically suggests a higher implied risk-neutral default rate, whereas a narrower spread indicates a lower implied risk. This connection explains why the information embedded in credit spreads can be used to infer the risk-neutral default rate, allowing investors and analysts to gauge the market's expectations regarding credit risks.