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Was looking at some sourced data and noticed that a 4 year annualized default probability was greater than a 5 year annualized default probability. This seems counter intuitive even in the case that most of their debt is in the short term with expectations of large positive cashflows in the mid/long term. Is it possible that this is just an artifact of annualizing raw default probabilities or could the sourced data be incorrect?

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  • $\begingroup$ Are the DPs in your source data, or do you calculate them from other data? $\endgroup$ Jul 19, 2023 at 14:24
  • $\begingroup$ @DimitriVulis The DP's are sourced from an outside vendor so I have no access to their methodology unfortunately. $\endgroup$
    – Derick
    Jul 19, 2023 at 14:34

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I don't think this is necessarily wrong.

For a contrived example, suppose the only thing that could possibly cause a given firm to default within the next five years is an event that occurs in one year (maybe a lawsuit). The firm has a 20% chance of defaulting as a result of this event in year 1.

Then, the (un-annualized) probability of survival for 4 years is $80\%$, and the probability of survival for 5 years is also $80\%$.

We can annualize and convert to probability of default for 4 years by taking $1 - 0.8 ^ \frac{1}{4} \sim 5.43\%$, or for 5 years by taking $1 - 0.8 ^ \frac{1}{5} \sim 4.36\%$

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    $\begingroup$ This does make sense, thank you for the response! $\endgroup$
    – Derick
    Jul 19, 2023 at 16:05

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