Explain carefully the distinction between real-world and risk-neutral default probabilities. Which is higher? A bank enters into a credit derivative where it agrees to pay $100 at the end of one year if a certain company’s credit rating falls from A to Baa or lower during the year. The one-year risk-free rate is 5%. Using Table 21.1, estimate a value for the derivative. What assumptions are you making? Do they tend to overstate or understate the value of the derivative?
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