The default probabilities backed out of CDS spreads are risk neutral probabilities
True
False
The correct answer and explanation is:
True
The default probabilities that are derived from Credit Default Swap (CDS) spreads are considered risk-neutral probabilities. Risk-neutral probabilities represent the likelihood of an event (like default) occurring, assuming that the market participants are indifferent to risk. In other words, they reflect the probability of default under the assumption that there is no risk premium associated with the investment, and the expected returns are adjusted to be in line with a risk-free rate.
CDS spreads are essentially the price of insurance against the default of a bond issuer. When an investor buys a CDS, they are paying a periodic fee (spread) in exchange for compensation in case the reference entity (such as a corporation or government) defaults on its debt. By analyzing the CDS spread, one can back out the probability of default, which is based on the market’s perception of the likelihood that the issuer will fail to make good on its obligations.
The calculation of these probabilities assumes that market participants are rational and that there is no risk aversion. This risk-neutral assumption is a key component in pricing derivatives and evaluating financial markets in general, especially in models such as the Black-Scholes or the binomial model. In the context of CDS, it implies that the probability of default derived from the spread is not adjusted for any risk premium that an investor might demand for taking on the credit risk of the reference entity.
In contrast, real-world probabilities of default (also known as “actual” or “true” probabilities) may differ as they would incorporate a risk premium to reflect the level of risk that investors are willing to take on. Therefore, the default probabilities implied by CDS spreads are not the same as the true or real-world probabilities, as they assume a risk-neutral world.