CAIA practice exam Q

  1. Similar to the term structure of interest rates, one can depict the term structure of credit default swap (CDS) spreads for a given reference entity. Which of the following credit curve shapes is consistent with the notion that the cumulative probability of defaulting increases over time? I. Downward sloping II. Flat III. Upward sloping A. I and II B. I, II and III C. II and III D. III only The answer is C. Why? I thought upward sloping only…

This is tough. I would have thought that the cumulative probability always increases. Aren’t probabilities (default in Y1, Y2 etc) independent? If you default in year 1, you cannot default in year 2 or later. Hence, I would have thought that if you add the probabilities, cumulative probability goes up anyway…

good question

credit curve shapes can be both upward sloping and flat (hazard rate is constant). the cumulative probability of default increases over time, even if the hazard rate is constant