The credit spreads for a counterparty for 5 and 6 years are 2% and 2.2% respectively.The recovery rate is 60%.What is closest to the unconditional default probability for the sixth year?

Question

Quizplus · Accepted Answer

The average hazard rate for the first five years is 0.02/(1-0.6)=0.05 or 5%.The average hazard rate for the first six years is 0.022/(1-0.6)=0.055 or 5.5%.The probability of no default during the first five years is therefore e^-0.05×5=0.7788.The probability of no default during the first six years is e^-0.055×6 =0.7189.The probability of default during the sixth year is therefore 0.7788−0.7189 or approximately 0.06.

The Credit Spreads for a Counterparty for 5 and 6