Statements I and II are correct. The credit spread (the difference between the risky bond rate and the riskfree rate) is a proxy for the annualized risk-neutral loss rate. However, the difference between the bond yield and the treasury yield is incorrect because of the state tax exemption awarded to treasuries and the high degree of liquidity for treasuries. Another proxy for the risk-neutral mean loss rate is the default swap rate paid by the protection buyer in a credit default swap agreement. |
