Probability of default

Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.

PD is used in a variety of credit analyses and risk management frameworks. Under Basel II, it is a key parameter used in the calculation of economic capital or regulatory capital for a banking institution.

PD is closely linked to the Expected Loss, which is defined as the product of the PD, the Loss Given Default (LGD) and the Exposure at Default (EAD).

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 obligor’s capacity to repay the debt in accordance with contractual terms. PD is generally associated with financial characteristics such as inadequate cash flow 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 quantifiable factors, the borrower’s willingness to repay also must be evaluated.

The probability of default is an estimate of the likelihood that the default event will occur. It applies to a particular assessment horizon, usually one year.

Credit scores, such as FICO for consumers or bond ratings from S&P, Fitch or Moodys for corporations or governments, typically imply a certain probability of default.

For group of obligors sharing similar credit risk characteristics such as a RMBS or pool of loans, a PD may be derived for a group of assets that is representative of the typical (average) obligor of the group. In comparison, a PD for a bond or commercial loan, are typically determined for a single entity.

Under Basel II, a default event on a debt obligation is said to have occurred if

The PD of an obligor not only depends on the risk characteristics of that particular obligor but also the economic environment and the degree to which it affects the obligor. Thus, the information available to estimate PD can be divided into two broad categories -

An unstressed PD is an estimate that the obligor will default over a particular time horizon considering the current macroeconomic as well as obligor specific 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.

...
Wikipedia