CreditPortfolio View / Conditional probability of default

[Jeffrey Chudy]

CreditPortfolio View / Conditional probability of default

[Anonymous]

Hi, can you please explain why the economic expansion makes the conditional prob of default lower than the UNconditional prob of default?

Question 166 : Under the CreditPortfolio View model of credit risk, the conditional probability of default will be:

(a) higher than the unconditional probability of default in an economic expansion
(b) lower than the unconditional probability of default in an economic contraction
(c) lower than the unconditional probability of default in an economic expansion
(d) the same as the unconditional probability of default in an economic expansion

The correct answer is choice ‘c’ When the economy is expanding, firms are less likely to default. Therefore the conditional probability of default, given an economic expansion, is likely to be lower than the unconditional probability of default. Therefore Choice ‘c’ is the correct answer and the other statements are incorrect.

[Anonymous]

In “good times” the likelihood of default will be lower than in “bad times”. So let’s say that in good times the probablity is 0.01 and in bad times it is 0.05. These are conditional probabilities, conditional on times being either good or bad. The Unconditional probability would be more of an overall average. It’s like ignoring the fact of whether we are in good times or bad. So the unconditional probability should be higher than the “good times” probability, but not as high as the “bad times” probability. So let’s say it is 0.03. So (c) is correct in that the conditional probability of default in an economic expansion (“good times”) is 0.01 which is lower than the unconditional probability of default, which is 0.03.
Actually, maybe the wording of the question makes it a bit confusing, especially the position of the term “in an economic expansion”. Maybe it would read better as, “the conditional probability of default in an economic expansion will lower than the unconditional probability of default”. What I’m getting at is that the term “in an economic expansion” only relates to the conditional probability of default.
At least that’s the way I understand it, but I could be wrong.

[Anonymous]

The ‘conditional’ here refers to the probability of default conditional on the economic expansion. Jim gives a good example – the UNconditional probability of default is the long term average default frequency covering both expansions and contractions, and will lie somewhere between the probability of default during good and bad times. The ‘conditional’ will refer to the state of the economy, and will be higher or lower than the unconditional.

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