CFA Practice Question

CFA Practice Question

Bonds with S and P rating BB+ have a default probability of 6.25% over the coming year. An analyst wants to calculate the expected number of defaults and the variance of the number of defaults for a portfolio of 8 bonds over the coming year. The analyst assumes a binomial model. What is the major weakness of assuming a binomial model in this case?
A. The size of the portfolio is too small to approximate the normal distribution.
B. The binomial model has parameters that are given here, so the mean and variance cannot be computed with the available information.
C. Defaults are not independent, as economy-wide conditions leading to defaults will impact many (or all) firms.
Explanation: We are not using the normal approximation, so size is irrelevant. Also, the required parameters of a binomial model are 'chance of success' and number, and both are given.

User Contributed Comments 1

User Comment
harrybay Binomial model assumes independant probabilities
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