Credit Risk Management Practice Exam

What does an upward sloping spread curve imply about future defaults?

1. Defaults will likely occur more frequently in the near term

2. Defaults will be constant over time

3. Defaults will likely be flatter in the short run, steeper later

4. Defaults will decrease over time

The correct answer is: Defaults will likely be flatter in the short run, steeper later

An upward sloping spread curve indicates that the risk premium required by investors is increasing for longer maturities compared to shorter ones. This typically suggests that market participants expect an increase in risk over time, which can often be associated with an increasing likelihood of defaults in the future. In the context of the choices, an upward sloping spread curve implies that while defaults may not occur immediately, there is an expectation that they will become more prevalent over time. The steepness of the curve could signify that investors anticipate a gradual increase in risk or default probabilities. Thus, defaults are seen as being flatter—suggesting relatively constant levels—in the short run, with expectations of becoming steeper, signaling higher default risks, later on. This reflects market sentiment that conditions may worsen or that economic uncertainty may rise, influencing the likelihood of defaults in the longer term. In this way, the upward sloping spread curve gives insights into investor expectations regarding credit risk and defaults, which aligns with the understanding that future defaults are likely to increase over time.