Inferring Default Probabilities from Credit Spreads

Abstract

Default probabilities (PDs) for risky obligors are derived from market spreads and spread volatilities. The method assumes that 1) credit spreads, on average, are linear functions of spread volatility and that 2) investors require the same spread compensation per unit of spread volatility regardless of its source. Credit spreads are decomposed into two parts: compensation for default and compensation for spread volatility. An analysis of the credit risk premium is described as a precursor to estimating default probabilities from market data. Finally, market-implied PDs are used to assess risk and relative value of global sovereign issuers of external debt.