The spread on a one-year BBB rated bond relative to the risk-free treasury of similar maturity is 2%. It is estimated that the contribution to this spread by all non-credit factors (e.g., liquidity risk, taxes) is 0.8%. Assuming the loss given detàult rate for the underlying credit is 60%, what is approximately the implied default probability for this bond?
A. 3.33%
B. 5.00%
C. 3.00%
D. 2.00%
Answer:D
The probability of default equa1s the credit risk spread divided by the loss given default. PD =spreadlLGD. Here, the spread due to credit risk equals 2.0% - 0.8% or 1.2% and the loss given default is 60%. The probability of default is then 2%.