Question

The spread between the yield on a 3-year corporate bond and the yield on a similar riskfree bond is 50 basis points. The recovery rate is $30 \%$. Estimate the average hazard rate per year over the 3-year period. 

   The spread between the yield on a 3-year corporate bond and the yield on a similar riskfree bond is 50 basis points. The recovery rate is $30 \%$. Estimate the average hazard rate per year over the 3-year period.
Options, Futures, and Other Derivatives
Options, Futures, and Other Derivatives
John C. Hull 10th Edition
Chapter 24, Problem 1 ↓

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In this case, the credit spread is 50 basis points, or 0.50%.  Show more…

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The spread between the yield on a 3-year corporate bond and the yield on a similar riskfree bond is 50 basis points. The recovery rate is $30 \%$. Estimate the average hazard rate per year over the 3-year period.
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Key Concepts

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Credit Spread
The credit spread is the additional yield that investors demand for bearing the credit risk of a corporate bond compared to a risk-free bond. It reflects the perceived additional risk of default and therefore compensates investors for potential losses.
Recovery Rate
The recovery rate is the proportion of the bond’s value that can be recovered by investors in the event of default. It is a crucial factor in estimating losses as it directly affects the loss given default, which is the risk component used in pricing credit risk.
Hazard Rate
The hazard rate, also known as the default intensity, is the annualized probability of a credit event (default) occurring. It is derived from the credit spread and the recovery rate by assuming that the spread approximates the product of the hazard rate and the loss given default (1 minus the recovery rate).
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Assume the following yields for different bonds issued by a corporation: If the on-the-run 3-year U.S. Treasury is yielding 5 percent, then what is the absolute yield spread on the 3-year corporate issue? One-year bond: 5.50% Two-year bond: 6.00% Three-year bond: 7.00% 0.4% 1.4% 100bp 200bp
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