Estimating Default Probabilities

Credit Ratings A credit rating is designed to provide information about default probabilities. . Rating agencies such as Moody¶s and S&P are in the business of providing ratings describing the credit worthiness of corporate bonds.

and balance sheet ratios.Internal Credit Ratings  Internal ratings based approaches for probability of default (PD) typically involve profitability ratios. .

Altman·s Z-Score  Altman attempted to predict defaults from five accounting ratios: X :Working Capital/ Total Assets X :Retained earnings/Total Assets 1 2 X Earnings before interest and taxes/ Total assets 3 : X Market value of equity/ Book value of total liabilities 4 : X :Sales/Total 5 Assets .

6 X4 +0. the company is unlikely to default.The Z-score was calculated as  Z= 1.4 X2 +3. If it is between 1. there is good chance of default.7 and 3.8. If it is less than 1.0.999 X5  If Z.7.0.2 X1 +1.3 X3 +0. .score is greater than 3. the probability of financial embarrassment is very high. If it is between 2. it should be ³on alert´.8 and 2.

09 0.91 3.68 1.12 0.76 3 0.04 0.29 0.21 .99 Rating 1 Aaa Aa A Baa Ba B 0.26 6.21 1.94 9.10 21.16 11.12 30.20 1.79 10 0.00 0.00 0.03 6.57 3.01 50.51 2.24 15.59 26.38 1.06 0.88 59.65 7 0.62 0.00 20.17 31.23 1.24 0.66 0.59 5.15 0.Historical default probabilities  Average cumulative default rates(%).02 0.02 0.54 2.44 40.1970-2003 Term (years) 4 5 0.48 13.62 8.21 2 0.02 15 1.43 0.00 0.03 0.

Recovery Rates  The recovery rate for a bond is normally defined as the bond¶s market value immediately after a default as a percent of its face value. .

and R is the expected recovery rate. h= s 1-R h is the default intensity per year.Estimating Default Probabilities From Bond Prices The probability of default for a company can be estimated from the prices of bonds it has issued.  . s is the spread of corporate bond yield over the risk-free rate.

. or equity prices. The probability that a company will default during a particular period of time in the future can be estimated from historical data. bond prices.