Edward Kapili is a summer intern working on a fixed-income trading desk at a major money-center bank. His supervisor asks him to value a three-year, 3% annual payment corporate bond using a binomial interest rate tree model for 20% volatility and the current par curve for benchmark government bonds. (This is the binomial tree in Exhibit 15.) The assumed annual probability of default is 1.50%, and the recovery rate is 40%.

The supervisor asks Mr. Kapili if the credit spread over the yield on the three-year benchmark bond, which is 1.50% in Exhibit 9, is likely to go up more if the default probability doubles to 3.00% or if the recovery rate halves to 20%. Mr. Kapili’s intuition is that doubling the probability of default has a larger impact on the credit spread. Is his intuition correct?