Probability of default
The chance a borrower fails to pay. One half of credit risk; how much is lost when it happens is the other.
Where you will meet it
Probability of default appears in 8 learning outcomes on the CFA syllabus. A few of them:
- Set out the elements that make up credit risk
“Expected loss is the product of the probability of default and the loss given default, which is one minus the recovery rate, applied to the amount exposed.”
- Explain expected exposure, probability of default, loss given default and the adjustment to value for credit (CVA)
“The probability of default for a period is the hazard rate multiplied by the probability of surviving to the start of that period, so it falls over time even with a constant hazard.”
- Explain the risks a manager must weigh when running a portfolio whose returns hinge on credit spreads
“Spread-based portfolios earn excess return over government bonds but carry credit risk in two forms: default risk (probability of default × loss given default) and spread risk, the price loss when spreads widen, measured by spread duration.”
- Weigh risk and return across private credit strategies, and set them against other private market assets, in a strategic allocation
“Deduct expected losses (probability of default × loss given default).”
Practise it
Practise probability of default until it is automatic: questions that explain every wrong option.
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