Tuesday, 28 September 2010

Implied default rates and compounding probabilities

I nice little primer on calculating implied default rates over at irisheconomy.ie. These are calculated under the assumption of no arbitrage, in that the expected value of the security with (implied or assumed) zero risk must be equal to or in excess of (under risk aversion) the expected value (probability weighted value) of the risky security.

The example there comes out for Ireland at about a 40% implied probability of default at some point over ten years. Sounds high, but think about this; a 40% probability of default in any of the next 10 years is equivalent to 5% probability of default in any single year.

Risk compounds just like interest rates.

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