Hi, been coming across this formula explaining risk neutral probability of default
Assume a 1-year, zero coupon bond trading at $95. One year benchmark rate is 3%.
Recovery rate = 60%
So,
(60p+100(1-p))/1.03 = 95
p = 5.38%, this is the risk neutral probability of default
Can someone please explain the theory of risk neutral probability of default in simple terms and how can I formulate the above formula?
Thank you!
All it’s saying is that if the assumption of a 60% recovery rate is accurate, then the $95 market price implies that the market thinks that the probability of default is 5.38%.
(Actually, the market probably never really thinks in detail about the probability of default. They arrive at the $95 price because it feels about right.)
@S2000magician Thank you so much for the prompt reply and the clear cut explanation! It’s easier to visualize and understand it this way
My pleasure.