Derivatives Foundation interview preparation

Questions

100

Traced to a firm

29

Firms

19

Updated

September 2026

Asked at

All firmsMSMorgan Stanley4Nomura4Akuna Capital2Amundi2HSBC2PIMCO2Bank of America1Barclays1Citadel1DRW1Goldman Sachs1Jane Street1Millennium Management1Mizuho1Old Mission Capital1RCRBC Capital Markets1Scotiabank1UBS1Wells Fargo Securities1

Topic

All topicsForwards and futures10Options basics8Option pricing7The Greeks10Volatility7Option strategies9Swaps and rates7Credit derivatives4Market structure and clearing6Indian derivatives8Trading and markets9Brainteasers6Fit9

Level

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Type

AnyTechnicalCaseMarket viewBrainteaserFit

1. 060A five-year CDS trades at 400 basis points. What does that tell you about the probability of default?Credit derivativesHardsuperdayCredit tradingRisk management

   Say this

   Roughly a 6 to 7 percent annual risk-neutral default probability, using the rule of thumb that spread equals default probability times loss given default. At a 40 percent recovery, 400 over 0.6 is about 667 basis points a year, so around 28 percent cumulative over five years. But that is a risk-neutral number, and it is meaningfully higher than the real-world probability.

   Then walk it

   1. The approximation: spread is approximately the hazard rate times one minus recovery. Invert it — hazard rate equals spread over loss given default. With 40 percent recovery assumed, 400 basis points implies about 6.7 percent a year.
   2. Cumulative over five years, compounding the survival probability: 0.933 to the fifth is about 0.71, so roughly a 29 percent chance of default over the life.
   3. The recovery assumption does a lot of work here. Assume 20 percent recovery instead and the implied hazard rate drops to 5 percent. So you cannot read a default probability out of a spread without a recovery view, and the two are jointly unidentified from the spread alone.
   4. The bigger point: this is a risk-neutral probability, which embeds a risk premium. Empirically risk-neutral default probabilities run perhaps two to three times realised default rates for investment grade credits, because investors demand compensation for default risk being correlated with bad times. Quoting 29 percent as the actual chance the company fails would be wrong.
   5. The spread also contains things that are not default risk: liquidity premium, the cost of dealer balance sheet, and for index CDS, the demand for macro hedges. In a stress event, spreads widen more than any credible reassessment of default odds justifies.
   6. So how I would use the number: as a market-implied ranking and a hedging cost, not as a forecast. If I wanted the real-world probability I would look at rating agency transition matrices or a structural model like Merton, and I would expect a considerably lower figure — and the gap between the two is itself the credit risk premium I might want to harvest.

   Where candidates lose it

   Quoting the risk-neutral number as the probability of default. The whole test is whether you know that the spread contains a risk premium, a liquidity component and a recovery assumption. Do the arithmetic, then correct it out loud.

   Expect next

   • How sensitive is your answer to the recovery assumption?
   • How would you get a real-world default probability instead?
   • Why do risk-neutral and real-world probabilities differ by so much?
2. 061What is the CDS-bond basis, and what does it mean when it goes negative?Credit derivativesHardsuperdayCredit tradingHedge funds

   Say this

   The basis is the CDS spread minus the bond's credit spread on the same issuer and maturity. In theory it should be near zero, because buying the bond and buying protection creates a near-riskless position. A negative basis — CDS cheaper than the cash bond spread — means the cash market is under stress and nobody has the balance sheet to arbitrage it.

   Then walk it

   1. The arbitrage in principle: buy the bond, buy CDS protection to the same maturity, and you have hedged default risk. The residual spread you earn should be roughly the risk-free rate, so a large positive residual is a negative basis trade.
   2. Why it does not get arbitraged away: the trade needs funding for the bond position and balance sheet at a dealer. In a crisis funding is expensive or unavailable, so the trade is theoretically profitable and practically impossible. That is why the basis went to hundreds of basis points negative in late 2008 and again in March 2020.
   3. So a deeply negative basis is a funding stress indicator, not a credit signal. It measures the scarcity of balance sheet rather than the probability of default.
   4. Structural reasons for a non-zero basis in normal times: the cheapest-to-deliver option in CDS makes protection worth slightly more than a specific bond's spread; CDS is unfunded so it attracts different investors; and CDS documentation covers restructuring events that a bond spread does not price identically.
   5. A positive basis usually reflects demand for protection that cannot easily be expressed in cash — for example when bonds are impossible to borrow, so the negative view has to be taken in CDS.
   6. The limitation for anyone thinking of the trade: it is not riskless. You carry the counterparty on the protection leg, you carry funding and margin risk that can force you out, and you carry basis risk on the exact maturity and deliverable. The 2008 version of this trade destroyed funds who were right about the convergence and could not survive the path.

   Where candidates lose it

   Calling a negative basis an arbitrage. The point is precisely that it is not — it persists because funding and balance sheet are the binding constraint, and that is why the size of the basis is a stress gauge. Say that, and name March 2020.

   Expect next

   • So why does the arbitrage not close?
   • What does a persistently positive basis tell you?
   • How would you fund and size a negative basis trade?

Firm tags come from public, anonymous candidate reports on Wall Street Oasis: strong signal, not sworn testimony. Firms are named as the places a question was reported, not as partners of Fin Maverick. Answers are written for this page to show how to think out loud; they are not scripts to recite.