FI4 Default Risk

A government bond and a corporate bond trade together. The corporate bond can default.

Objective

Price the default risk in RISKY against SAFE. Assessed on profit and loss, with closing positions valued at the final value.

What it shows

• A credit spread as the price of default risk.
• The spread as the gap between a bond that pays and one that may not.
• A bond that ends at one of two values, so its price is a probability.

Watch out for

• Reading the higher yield on RISKY as free return.
• A default that is drawn at the close, so the price could not show it.
• Sizing a position to the expected loss and not the worst one.

Who takes part

• Trader — every student. Trades SAFE, a government bond, and RISKY, a corporate bond.

Class size

Ten to forty students in one role.