PPT Slide

Example

Valuation of a zero coupon bond with a promised payment in a year of

$100, with a recovery of (1 - LGD) upon issuer’s default.

* LGD = loss given default (assumed to be 40% here)

Q = risk neutral probability that the issuer defaults in one year from

now (assumed to be 20% here)

The expectation is calculated using the risk neutral probabilities but

not the actual probabilities as they can be observed in the market from

historical data or EDFs.