hard · FRM Part 2 Credit Risk
A credit analyst notes that a borrower's credit default swap (CDS) spread curve is 'inverted' (short-term spreads are higher than long-term spreads).
What is the most likely fundamental interpretation of this signal according to reduced-form modeling principles?
- The market expects the borrower's credit quality to improve significantly in the long run after surviving a near-term liquidity crisis.
- Interest rates are expected to fall soon, which mechanically lowers long-term credit spreads relative to short-term ones.
- The risk-neutral default probability is assumed constant over time, but the expected recovery rate (RR) is projected to decline going forward.
- The borrower is fundamentally stable and well-capitalized, and the inversion is simply a liquidity artifact within the CDS market.
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