First, we calculate the credit spread (s): $s = \text{Bond Yield} - \text{Risk-Free Rate} = 7\% - 3\% = 4\% = 0.04$

Using the reduced-form model approach, the hazard rate ($\lambda$) can be approximated as: $\lambda = \frac{s}{1 - \text{Recovery Rate}} = \frac{0.04}{1 - 0.40} = \frac{0.04}{0.60} \approx 0.06667$

The probability of surviving year 1 ($S_1$) is: $S_1 = e^{-\lambda \times 1} = e^{-0.06667} \approx 0.9355$

The probability of surviving year 2 ($S_2$) is: $S_2 = e^{-\lambda \times 2} = e^{-0.13333} \approx 0.8752$

The probability of default in the second year is the probability of surviving the first year and defaulting in the second year: $\text{PD}_{\text{Year 2}} = S_1 - S_2 = 0.9355 - 0.8752 = 0.0603$