Financial Risk Manager Part 2

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What is the primary distinction between real-world default probabilities and risk-neutral default probabilities in credit risk analysis?

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A

Real-world probabilities are derived from theoretical models, while risk-neutral probabilities are grounded in empirical evidence and market observations.

B

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Real-world probabilities consider the inherent uncertainties of the financial market, whereas risk-neutral probabilities assume a risk-free environment without any additional return demands.

C

Risk-neutral probabilities are more suitable for scenario analysis and stress testing, while real-world probabilities are appropriate for valuing financial instruments consistently with other market instruments.

D

Risk-neutral probabilities are lower than real-world probabilities due to the expected risk premium, while real-world probabilities are higher as they align with arbitrage-free pricing principles.

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