Probability of Default is the one of the key metric used to identify the creditworthiness of a customer. It helps us to estimate the chances that customer would make payments on time or would remain solvent during the period of mortgage.
Various statistical techniques can be employed to develop PD models. PD models are broadly divided into two categories.
- Point in Time PD: PiT PD tries to capture the variations in economic cycle and thus move along with it. PiT PD models use the current macro-economic conditions and thus the PD scores will closely track the business cycle.
- Through the Cycle (TTC): TTC PD model tries to capture only characteristics of individual customers.
To further demystify the difference between two types of PD, we need to understand that the Probability of default of an obligor not only depends upon the risk characteristics of that particular obligor but also on the macro economic conditions.
While developing Pit PD we capture both current macro-economic conditions and risk characteristics of customers. The PiT PD goes up as macro-economic conditions deteriorates and goes down as macro-economic conditions improve.
Whereas, in TTC PD we try to model risk characteristics of an individual while keeping the macro-economic conditions static. Accordingly, if we plot PiT PD and TTC PD for any obligor, we will observe much more variation for PiT PD while TTC PD would be give somewhere near the average of PiT PD.
Let us look into another example of Stresses and Un-Stressed PD.
Un-Stressed PD: An unstressed PD is an estimate that the obligor will default over a particular time horizon considering the current macroeconomic as well as obligor specific information. This implies that if the macroeconomic conditions deteriorate, the PD of an obligor will tend to increase while it will tend to decrease if economic conditions improve.
Stressed PD: A stressed PD is an estimate that the obligor will default over a particular time horizon considering the current obligor specific information, but considering “stressed” macroeconomic factors irrespective of the current state of the economy. The stressed PD of an obligor changes over time depending on the risk characteristics of the obligor, but is not heavily affected by changes in the economic cycle as adverse economic conditions are already factored into the estimate.
The stressed PD defined above usually denotes the TTC PD of an obligor whereas the unstressed PD denotes the PIT PD