Probability of default

Probability of default (PD) is a nancial term describing 2 Stressed and Unstressed PD

the likelihood of a default over a particular time horizon.
It provides an estimate of the likelihood that a borrower The PD of an obligor not only depends on the risk charwill be unable to meet its debt obligations.[1][2]
acteristics of that particular obligor but also the ecoPD is used in a variety of credit analyses and risk manage- nomic environment and the degree to which it aects the
ment frameworks. Under Basel II, it is a key parameter obligor. Thus, the information available to estimate PD
used in the calculation of economic capital or regulatory can be divided into two broad categories capital for a banking institution.
Macroeconomic information like house price indices, unemployment, GDP growth rates, etc. - this
information remains the same for multiple obligors.
1 Overview
Obligor specic information like revenue growth
(wholesale), number of times delinquent in the past
six months (retail), etc. - this information is specic
to a single obligor and can be either static or dynamic
in nature. Examples of static characteristics are industry for wholesale loans and origination loan to
value ratio for retail loans.

PD is the risk that the borrower will be

unable or unwilling to repay its debt in full
or on time. The risk of default is derived by
analyzing the obligors capacity to repay the
debt in accordance with contractual terms. PD
is generally associated with nancial characteristics such as inadequate cash ow to service
debt, declining revenues or operating margins,
high leverage, declining or marginal liquidity,
and the inability to successfully implement a
business plan. In addition to these quantiable
factors, the borrowers willingness to repay
also must be evaluated.
[Oce of the Comptroller of the Currency]

An unstressed PD is an estimate that the obligor will default over a particular time horizon considering the current macroeconomic as well as obligor specic information. This implies that if the macroeconomic conditions
deteriorate, the PD of an obligor will tend to increase
while it will tend to decrease if economic conditions improve.

A stressed PD is an estimate that the obligor will default

The probability of default is an estimate of the likelihood
over a particular time horizon considering the current
that the default event will occur. It applies to a particular
obligor specic information, but considering stressed
assessment horizon, usually one year.
macroeconomic factors irrespective of the current state
Credit scores, such as FICO for consumers or bond rat- of the economy. The stressed PD of an obligor changes
ings from S&P, Fitch or Moodys for corporations or gov- over time depending on the risk characteristics of the
ernments, typically imply a certain probability of default. obligor, but is not heavily aected by changes in the ecoFor group of obligors sharing similar credit risk charac- nomic cycle as adverse economic conditions are already
teristics such as a RMBS or pool of loans, a PD may be factored into the estimate.
derived for a group of assets that is representative of the For a more detailed conceptual explanation of stressed
typical (average) obligor of the group.[3] In comparison, and unstressed PD, refer.[5]:12, 13
a PD for a bond or commercial loan, are typically determined for a single entity.

3 Through-the-cycle(TTC)
Point-in-Time(PIT)

Under Basel II, a default event on a debt obligation is said

to have occurred if[4]

and

it is unlikely that the obligor will be able to repay

its debt to the bank without giving up any pledged Closely related to the concept of stressed and unstressed
PDs, the terms through-the-cycle (TTC) or point-in-time
collateral
(PIT) can be used both in the context of PD as well as rat the obligor is more than 90 days past due on a ma- ing system. In the context of PD, the stressed PD dened
terial credit obligation
above usually denotes the TTC PD of an obligor whereas
1

4 DERIVING POINT-IN-TIME(PIT) AND THROUGH-THE-CYCLE(TTC) PDS

the unstressed PD denotes the PIT PD.[6] In the context

of rating systems, a PIT rating system assigns each obligor
to a bucket such that all obligors in a bucket share similar
unstressed PDs while all obligors in a risk bucket assigned
by a TTC rating system share similar stressed PDs.[5]:14
Credit default swap-implied (CDS-implied) probabilities
of default are based upon the market prices of credit default swaps. Like equity prices, their prices contain all information available to the market as a whole. As such, the
probabliity of default can be inferred by the price. CDS
implied PDs can be used with EDF (Expected Default
Frequency) credit measures to improve accuracy.[7]

Deriving
Point-in-Time(PIT)
and
Through-the-cycle(TTC)
PDs

There are alternative approaches for deriving and estimating PIT and TTC PDs. One such framework [8][9] involves distinguishing PIT and TTC PDs by means of systematic predictable uctuations in credit conditions, i.e.
by means of a credit cycle. This framework, involving
the selective use of either PIT or TTC PDs for dierent
purposes, has been successfully implemented in large UK
banks with BASEL II AIRB status.
As a rst step this framework makes use of Merton approach [10] in which leverage and volatility (or their proxies) are used to create a PD model.
As a second step, this framework assumes existence of
systematic factor(s) similar to Asymptotic Risk Factor
Model (ASRF).[11][12]
As a third step, this framework makes use of predictability of credit cycles. This means that if the default rate in
a sector is near historic high then one would assume it to
fall and if the default rate in a sector is near historic low
then one would assume it to rise. In contrast to other approaches which assumes the systematic factor to be completely random, this framework quanties the predictable
component of the systematic factor which results in more
accurate prediction of default rates.
As per this framework, the term PIT applies to PDs that
move over time in tandem with realized, default rates
(DRs), increasing as general credit conditions deteriorate
and decreasing as conditions improve. The term TTC applies to PDs that exhibit no such uctuations, remaining
xed overall even as general credit conditions wax and
wane. The TTC PDs of dierent entities will change, but
the overall average across all entities wont. The greater
accuracy of PIT PDs makes them the preferred choice
in such current, risk applications as pricing or portfolio
management. The overall stability of TTC PDs makes
them attractive in such applications as determining Basel
II/II RWA.

The above framework provides a method to quantify

credit cycles, their systematic and random components
and resulting PIT and TTC PDs. This is accomplished
for wholesale credit by summarizing, for each of several
industries or regions, MKMV EDFs, Kamakura Default
Probabilities (KDPs), or some other, comprehensive set
of PIT PDs or DRs. After that, one transforms these factors into convenient units and expressed them as deviations from their respective, long-run-average values. The
unit transformation typically involves the application of
the inverse-normal distribution function, thereby converting measures of median or average PDs into measures of
median or average default distance (DD). At this point,
one has a set of indices measuring the distance between
current and long-run-average DD in each of a selected
set of sectors. Depending on data availability and portfolio requirements, such indices can be created for various
industries and regions with 20+ years covering multiple
recessions.
After developing these indices, one can calculate both
PIT and TTC PDs for counterparties within each of the
covered sectors. To obtain PIT PDs, one introduces
the relevant indices into the relevant default models, recalibrate the models to defaults, and apply the models
with current and projected changes in indices as inputs.
If a PD model werent otherwise PIT, the introduction
of the indices will make it PIT. The specic model formulation depends on the features important to each, distinguished class of counterparties and data constraints.
Some common approaches include:
Factor Ratio Model: Calibration of nancial/nonnancial factors and credit-cycle indices to defaults.
This approach works well with large number of defaults, e.g. SME portfolios or large-corporate portfolios calibrated to external default samples.
Scorecard model: Calibration of score and creditcycle indices calibrated to observed internal or external defaults. This approach works with smaller
number of defaults where there is not enough data
to develop a ratio model. E.g. Funds portfolio
Agency Direct model: Calibration of ECAI grades
(enumerated as default distance) and credit indices
to ECAI defaults and applying it to Agency and
internal co-rated entities. This approach works
well where there is a large co-rated dataset but not
enough internal defaults e.g. Insurance portfolio
Agency Replication model: Calibrate nancial/nonnancial factors/scorecard score to PDs estimated
from the Agency Direct model. This approach
works well where there is a large, co-rated dataset
but a small sample of internal defaultse.g. Insurance portfolio
External vendor model: Use of models such as
MKMV EDF model with credit cycle indices.

3
At this point, to determine a TTC PD, one follows three
steps:
Converting the PIT PD to PIT DD
Subtracting the credit cycle index from the PIT DD,
thereby obtaining the TTC DD; and
Converting the TTC DD to TTC PD.
In addition to PD models, this framework can also be
used to develop PIT and TTC variants of LGD, EAD and
Stress Testing models.

PD Estimation

Loss given default (LGD) magnitude of likely

loss on the exposure, expressed as a percentage
of the exposure
Probability of default (PD) probability of default of a borrower (This page.)
Exposure at default (EAD) amount to which
the bank was exposed to the borrower at the
time of default, measured in currency
For the eects of correlation between PD and LGD
see Expected loss

7 References
[1] Bankopedia:PD Denition
[2] FT Lexicon:Probability of default

There are many alternatives for estimating the probability of default. Default probabilities may be estimated
from a historical data base of actual defaults using modern techniques like logistic regression. Default probabilities may also be estimated from the observable prices
of credit default swaps, bonds, and options on common
stock. The simplest approach, taken by many banks, is to
use external ratings agencies such as Standard and Poors,
Fitch or Moodys Investors Service for estimating PDs
from historical default experience. For small business default probability estimation, logistic regression is again
the most common technique for estimating the drivers
of default for a small business based on a historical data
base of defaults. These models are both developed internally and supplied by third parties. A similar approach is
taken to retail default, using the term credit score as a
euphemism for the default probability which is the true
focus of the lender.

[3] Introduction:Issues in the credit risk modelling of retail

markets
[4] Basel II Comprehensive Version, Pg 100
[5] BIS:Studies on the Validation of Internal Rating Systems
[6] Slides 5 and 6:The Distinction between PIT and TTC
Credit Measures
[7] http://www.moodysanalytics.com/~{}/media/Insight/
Quantitative-Research/Default-and-Recovery/
10-11-03-CDS-Implied-EDF-Credit-Measures-and-Fair-Value-Spreads.
ashx>
[8] http://mpra.ub.uni-muenchen.de/6902/1/aguais_et_al_
basel_handbook2_jan07.pdf
[9] Aguais, S. D., et al, 2004, Point-in-Time versus Throughthe-Cycle Ratings, in M. Ong (ed), The Basel Handbook:
A Guide for Financial Practitioners (London: Risk Books)

Some of the popular statistical methods which have [10] Merton, Robert C., On the Pricing of Corporate Debt:
The Risk Structure of Interest Rates, Journal of Finance,
been used to model probability of default are listed
Vol. 29, No. 2, (May 1974), pp. 449-470
[13]:112
below.
Linear Regression

[11] Gordy, M. B. (2003) A risk-factor model foundation for

ratings-based bank capital rules. Journal of Financial Intermediation 12, 199 - 232.

Discriminant analysis

[12] http://www.bis.org/bcbs/irbriskweight.pdf

Logit and Probit Models

[13] The Basel II Risk Parameters

Panel models
Cox proportional hazards model
Neural Networks
Classication Trees

See also
Expected loss and its three factors

8 Reading
de Servigny, Arnaud and Olivier Renault (2004).
The Standard & Poors Guide to Measuring and
Managing Credit Risk. McGraw-Hill. ISBN 9780-07-141755-6.
Due, Darrell and Kenneth J. Singleton (2003).
Credit Risk: Pricing, Measurement, and Management. Princeton University Press. ISBN 978-0-69109046-7.

External links
Implied Default Probability from CDS - QuantCalc,
Online Financial Math Calculator
http://papers.ssrn.com/sol3/Delivery.cfm/
SSRN_ID1921419_code282731.pdf?abstractid=
1921419&mirid=1 Through-the-Cycle EDF Credit
Measures methodology paper
http://www.bis.org/publ/bcbsca.htm Basel II: Revised international capital framework (BCBS)
http://www.bis.org/publ/bcbs107.htm Basel II: International Convergence of Capital Measurement
and Capital Standards: a Revised Framework
(BCBS)
http://www.bis.org/publ/bcbs118.htm Basel II: International Convergence of Capital Measurement
and Capital Standards: a Revised Framework
(BCBS) (November 2005 Revision)
http://www.bis.org/publ/bcbs128.pdf Basel II: International Convergence of Capital Measurement
and Capital Standards: a Revised Framework, Comprehensive Version (BCBS) (June 2006 Revision)

EXTERNAL LINKS

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