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, which naturally lowers long-term credit spreads.
- The risk-neutral probability of default is constant, but the recovery rate (RR) is expected to decline in the future.
- The borrower is highly stable, and the inversion is a liquidity artifact in the CDS market.
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