Credit Risk Management Practice Exam

What does the hazard rate represent in credit risk management?

1. Default correlation among assets

2. Probability of default (PD)

3. Liquidity risk

4. Market volatility

The correct answer is: Probability of default (PD)

The hazard rate is a crucial concept in credit risk management as it provides insight into the likelihood of an entity defaulting on its financial obligations over a specific time frame. Specifically, the hazard rate quantifies the instantaneous risk of default at any given moment, given that the entity has survived up until that point in time. This means that if you were to observe a loan or bond and wanted to determine how likely it is that the borrower will default in the near future, you would look at the hazard rate. It's essentially a function used to derive the probability of default, which is fundamental for assessing credit risk. In contrast, default correlation among assets, liquidity risk, and market volatility refer to different aspects of risk management and do not specifically address the timing or the instantaneous nature of default risks inherent in credit profiles. Hence, the correct representation of the hazard rate directly aligns with the probability of default.