Market-implied risk-neutral probabilities, actual probabilities, credit risk and news

Abstract

Motivated by the credit crisis, this paper investigates links between risk-neutral probabilities of default implied by markets (e.g. from yield spreads) and their actual counterparts (e.g. from ratings). It discusses differences between the two and clarifies underlying economic intuition using simple representations of credit risk pricing. Observed large differences across bonds in the ratio of the two probabilities are shown to imply that apparently safer securities can be more sensitive to news.