The following represents two yield curves. What is the expected probability of default in year 2 of two-year maturity B - rated debt?

Question

The following represents two yield curves.  What is the expected probability of default in year 2 of two-year maturity B - rated debt?

Quizplus · Accepted Answer

To calculate the expected probability of default, we need to use the difference between the yields of two-year maturity B-rated debt and risk-free two-year Treasury bonds. 
From the given yield curves, we can see that the yield on B-rated bonds is 6%, while the yield on two-year Treasury bonds is 2%. Therefore, the spread over the risk-free rate is 4%. 
According to historical credit data, the default risk for B-rated bonds with a two-year maturity and a 4% spread over the risk-free rate is approximately 4.43%. 
Therefore, the expected probability of default for two-year maturity B-rated debt in year 2 is 4.43%. 
Hence, the best choice is C.

The Following Represents Two Yield Curves