The Following Information Relates to Questions
Lena Liecken Is

question 1

Multiple Choice

The following information relates to Questions
lena liecken is a senior bond analyst at taurus investment Management. Kristel Kreming,
a junior analyst, works for liecken in helping conduct fixed-income research for the firm's
portfolio managers. liecken and Kreming meet to discuss several bond positions held in the
firm's portfolios.
bonds i and ii both have a maturity of one year, an annual coupon rate of 5%, and a mar-
ket price equal to par value. The risk-free rate is 3%. historical default experiences of bonds
comparable to bonds i and ii are presented in exhibit 1.
EXHIBIT 1 Credit Risk Information for Comparable Bonds

$\begin{array}{lcc}&&\text { Percentage of Bonds That}\\&&\text { Survive and Make Full}\\\text { Bond } & \text { Recovery Rate } & \text { Payment } \\\hline \text { I } & 40 \% & 98 \% \\\text { II } & 35 \% & 99 \% \\\hline\end{array}$
Bond III
Bond III is a zero-coupon bond with three years to maturity. Liecken evaluates similar bonds and estimates a recovery rate of $38 \%$ and a risk-neutral default probability of $2 \%$ , assuming conditional probabilities of default. Kreming creates Exhibit 2 to compute Bond III's credit valuation adjustment. She assumes a flat yield curve at $3 \%$ , with exposure, recovery, and loss given default values expressed per 100 of par value.
$$\begin{array}{l}\text { EXHIBIT } 2 \text { Analysis of Bond III }\\\begin{array} { l c c c c c c c } \hline \text { Date } & \text { Exposure } & \text { Recovery } & \begin{array} { c } \text { Loss Given } \\\text { Default }\end{array} & \begin{array} { c } \text { Probability } \\\text { of Default }\end{array} & \begin{array} { c } \text { Probability } \\\text { of Survival }\end{array} & \begin{array} { c } \text { Expected } \\\text { Loss }\end{array} & \begin{array} { c } \text { Present Value } \\\text { of Expected } \\\text { Loss }\end{array} \\\hline 0 & & & & & & & \\1 & 94.2596 & 35.8186 & 58.4410 & 2.0000 \% & 98.0000 \% & 1.1688 & 1.1348 \\2 & 97.0874 & 36.8932 & 60.1942 & 1.9600 \% & 96.0400 \% & 1.1798 & 1.1121 \\3 & 100.0000 & 38.0000 & 62.0000 & \underline{1.9208 \% }& 94.1192 \% & \underline{1.1909} &\underline{ 1.0898} \\ \text { Sum } & & & & 5.8808 \% & & 3.5395 & 3.3367 \\\hline\end{array}\end{array}$$
Bond IV
Bond IV is an AA rated bond that matures in five years, has a coupon rate of $6 \%$ , and a modified duration of 4.2. Liecken is concerned about whether this bond will be downgraded to an A rating, but she does not expect the bond to default during the next year. Kreming constructs a partial transition matrix, which is presented in Exhibit 3, and suggests using a model to predict the rating change of Bond IV using leverage ratios, return on assets, and macroeconomic variables.
$$\begin{array}{l}\text { EXHIBIT } 3 \text { Partial One-Year Corporate Transition Matrix (entries in \%) }\\\begin{array} { l r c c } \hline \text { From/To } & \text { AAA } & \text { AA } & \text { A } \\\hline \text { AAA } & 92.00 & 6.00 & 1.00 \\\text { AA } & 2.00 & 89.00 & 8.00 \\\text { A } & 0.05 & 1.00 & 85.00 \\\text { Credit Spread (\%) } & 0.50 & 1.00 & 1.75 \\\hline\end{array}\end{array}$$
Default Probabilities

Kreming calculates the risk-neutral probabilities, compares them with the actual default probabilities of bonds evaluated over the past 10 years, and observes that the actual and risk-neutral probabilities differ. She makes two observations regarding the comparison of these probabilities:

Observation 1: Actual default probabilities include the default risk premium associated with the uncertainty in the timing of the possible default loss.

Observation 2: The observed spread over the yield on a risk-free bond in practice includes liquidity and tax considerations, in addition to credit risk.
-Which of Kreming's observations regarding actual and risk-neutral default probabilities is correct?

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Definitions:

Accepting Deposits

A banking activity that involves receiving money from customers for safekeeping or for earning interest, typically in savings or checking accounts.

Systematically Important

Refers to entities or institutions whose failure could trigger a financial crisis, necessitating regulatory oversight to ensure stability.

Economic Growth

An increase in a country's capacity to produce goods and services, compared from one period of time to another.

Credit Default Swaps

Financial derivatives that allow an investor to swap or offset their credit risk with that of another investor.