Credit Risk Management Practice Exam

Why are CDS spreads useful for estimating hazard rates?

1. They are non-standardized and illiquid

2. They only apply to short maturities

3. They are liquid and span multiple maturities

4. They are determined by credit ratings

The correct answer is: They are liquid and span multiple maturities

CDS spreads are particularly useful for estimating hazard rates because they represent the cost of default protection on a specific reference entity, thus reflecting the credit risk associated with that entity. The liquidity of CDS markets allows for more accurate pricing based on real market transactions, rather than theoretical values. Additionally, CDS spreads span multiple maturities, which means they provide a continuous view of credit risk across different time horizons. This ability to analyze spreads over varying timeframes helps in constructing a more reliable estimate of hazard rates, which are essential for assessing the likelihood of default within certain periods. The other options have limitations: - Non-standardized and illiquid products would not yield reliable market signals. - The association with short maturities would restrict the analysis and understanding of the hazard rate over different timeframes, which is critical in risk management. - While credit ratings do influence CDS spreads, they do not directly determine them, and relying solely on ratings might oversimplify the complex factors affecting credit risk. Thus, the option that acknowledges the liquidity and range of maturities is indeed the most relevant for hazard rate estimation.