Default Probability

AAA

DEFINITION of 'Default Probability'

The degree of likelihood that the borrower of a loan or debt will not be able to make the necessary scheduled repayments. Should the borrower be unable to pay, they are then said to be in default of the debt, at which point the lenders of the debt have legal avenues to attempt obtaining at least partial repayment. Generally speaking, the higher the default probability a lender estimates a borrower to have, the higher the interest rate the lender will charge the borrower (as compensation for bearing higher default risk).

INVESTOPEDIA EXPLAINS 'Default Probability'

Most people encounter the concept of default probability when they go through the process of purchasing a residence. When a home buyer obtains a mortgage on a piece of real estate, the lending bank makes an assessment of the buyer's default risk and estimates their default probability. The higher this estimated probability, the greater the interest rate applied to the loan.

The same logic comes into play when investors buy and sell fixed-income securities on the open market. Companies that are cash-flush and have a low default probability will be able to issue debt at lower interest rates. Investors trading their bonds on the open market will price safer debt with a bit of a premium compared to riskier debt. If a company's financial health worsens over time, investors in the bond market will adjust to the increased risk and trade its bonds at lower prices.

RELATED TERMS
  1. Credit Rating

    An assessment of the credit worthiness of a borrower in general ...
  2. Skip Account

    A borrower who defaults on a loan and skips out on repayment ...
  3. Credit Cliff

    A slang term referring to the compounding of a company's credit ...
  4. Default

    1. The failure to promptly pay interest or principal when due. ...
  5. Default Risk

    The event in which companies or individuals will be unable to ...
  6. Credit Risk

    The risk of loss of principal or loss of a financial reward stemming ...
RELATED FAQS
  1. What factors are taken into account to quantify credit risk?

    The quantification of credit risk, assigning measurable and comparable numbers to the likelihood of default or spread risk, ... Read Full Answer >>
  2. Are high-yield bonds better investments than low-yield bonds?

    Most bonds typically make periodic payments, known as coupon payments, to the bondholder. A bond's indenture, which will ... Read Full Answer >>
  3. What are the risks of investing in a bond?

    The most well-known risk in the bond market is interest rate risk - the risk that bond prices will fall as interest rates ... Read Full Answer >>
  4. How is a corporate bond taxed?

    A corporate bond is taxed through the interest earned on the bond, through capital gains or losses earned in the early sale ... Read Full Answer >>
  5. How do I use the principles of convexity to compare bonds?

    Convexity, along with another principle known as duration, is an important consideration when assessing bond risk. All else ... Read Full Answer >>
  6. What is affected by the interest rate risk?

    Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate. Interest rate risk directly ... Read Full Answer >>
Related Articles
  1. Investing Basics

    What Is A Corporate Credit Rating?

    Is the bond you're buying investment grade, or just junk? Find out how to check the score.
  2. Bonds & Fixed Income

    Are High-Yield Bonds Too Risky?

    Despite their reputation, the debt securities known as "junk bonds" may actually reduce risk in your portfolio.
  3. Entrepreneurship

    Calculating (Small) Company Credit Risk

    Determining creditworthiness of smaller and medium-sized corporations isn't as easy as for larger companies, but these tips can help.
  4. Bonds & Fixed Income

    Muni Bonds, Taxable Bonds or CDs: Which is Best?

    Here's how to tell if municipal bonds are a better investment than taxable bonds or CDs.
  5. Investing

    The Strong Dollar’s (Real) Toll On Tech Stocks

    A large portion of U.S. technology companies’ sales occur overseas, given the strong international business and consumer demand from many U.S. tech firms.
  6. Fundamental Analysis

    How to Calculate a Coverage Ratio

    In broad terms, the higher the coverage ratio, the better the ability of the enterprise to fulfill its obligations to its lenders.
  7. Professionals

    Why You Should Avoid Fixating on Bond Duration

    Financial advisors and their clients should then focus on a bond fund’s portfolio rather than relying on any single metric like duration.
  8. Investing

    The Case For Stocks Today

    Last week, U.S. equities advanced with the S&P 500 Index notching new records. Investors are now getting nervous with rate and currency volatility spiking.
  9. Mutual Funds & ETFs

    Why You May Want To Be (And Stay) In Bonds

    Bonds are complicated, and it’s easy to feel intimidated or confused. Fortunately, you don’t need to be a numbers geek to be an informed investor.
  10. Home & Auto

    What Are The Tax Advantages Of Buying A Home?

    Don't forget these deductions and credits that homeowners can use to reduce their tax bill.

You May Also Like

Hot Definitions
  1. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  2. Covered Call

    An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset ...
  3. Butterfly Spread

    A neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration ...
  4. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
  5. Moving Average - MA

    A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random ...
  6. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
Trading Center