Sep 11

Probability of default implied by spot rates – 6 min screencast

by David Harper, CFA, FRM, CIPM

A brief look at using spot rates in the term structure to infer the probability of default (PD) on the risky bond. For FRM candidates, this is based on Saunders’ 11-4. Please note this is a simple model: it works by assuming the investor is indifferent to two bonds with identical expected returns (i.e., the risky bond’s expected return is its probability-adjusted promised return) but it does not account for risk differences between the two bonds. That is, it assumes the investor is not risk averse and therefore it gives risk-neutral probabilities.

Screencast: