Default Distribution and Credit Market Implications

We study the implied default distributions for the iTraxx-CJ tranches by means of the Principle of Maximum Entropy. The profiles are quite different from those of some popular probabilistic models. We show how to analyze the correlation structures, the conditional default probabilities pi,j and conditional default correlations ρi,j . Here the subscript i,j means that the default probability and correlation are estimated under i obligors are defaulted and j obligors are non-defaulted among N obligors. The implied default distribution, ρi,0 shows singular behavior, jumps high and then decreases rapidly to zero with i. Correspondingly pi,0 increases with i and saturates to some maximum value below 1. Such a behavior implies that the credit market expects a medium-size avalanche. We also discuss the “True” default correlation implied by the market quotes. PACS numbers: 89.65.-s,02.50.-r † to whom correspondence should be addressed ([email protected]) Implied Default Distribution 2