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 1 year if a certain company's credit rating falls from A to Baa or lower during the year.
The 1-year risk-free rate is 5%. Using Table 23.6, estimate a value for the derivative.
What assumptions are you making? Do they tend to overstate or understate the value of the derivative.