In the context of credit risk modeling, reduced form models are commonly used to estimate the likelihood of default and the associated recovery rates. These models utilize observable market data to infer the probability of credit events without necessarily modeling the underlying process of the issuer's cash flow.
Consider a company that has bonds trading at a spread over a risk-free benchmark. The company's spread is 200 basis points, and the market consensus implies a default probability of 3% over the next year. The recovery rate is estimated to be 40% in the event of default. If you are considering using a reduced form model for this company's bonds, which of the following statements is TRUE regarding the estimated expected loss on these bonds?