Measuring Actuarial Default Risk*
Default risk is the primary driver of credit risk. It is represented by the probability of default (PD). When default occurs, the actual loss is the combination of exposure at default (EAD) and loss given default (LGD).
Default risk can be measured using two approaches: (1) actuarial methods, which provide objective measures of default rates, usually based on historical default data; and (2) market-price methods, which infer from traded prices of debt, equity, or credit derivatives risk-neutral measures of default risk.
Risk-neutral measures were introduced earlier in relation to option prices. They are required for proper asset pricing. In addition, a major benefit of risk-neutral measures is that they are forward-looking and responsive to the latest news because they are based on current market prices.
For risk management purposes, however, they are contaminated by the effect of risk premiums and contain measures of loss given default. As a result, they do not directly measure default probabilities. In contrast, objective measures describe the actual or natural probability of default.
Actuarial measures of default probabilities are provided by credit rating agencies (CRAs), which classify borrowers by credit ratings that are supposed to quantify default risk. Such ratings are external to the institution using them. Similar techniques can be used to develop internal ratings.
Ratings usually start with accounting variables models, which ...