June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 50 of 92 default on loan payments will result in default on performance of the contract. However, it will make sense for companies to stress test their results to model potential Force Majeure or other events that could cause contractual non- performance. There are essentially three basic approaches in determining the default probability for a particular counterparty or credit classification of counterparties. 1. Historical Based 2. Bond Based 3. Equity Based There are other methods, such as utilizing credit default swaps however, this paper will focus on these most widely used methods. These methods are reviewed below to demonstrate how they can be utilized and examine some of their strengths and weaknesses. 5.3. Historical Based Approach This method is by far the simplest and least costly of the approaches to implement. The rating agencies routinely publish historical default rates for the various credit ratings and some companies maintain internal databases with such information. While this method is straight forward and it is based on real world data, it is backwards looking and does not tell the practitioner anything about potential future events. Below is a table of historical default rates as published in S&P’s ‘Credit Week’ (April 15, 1996). Table 5-1 Average Cumulative Default Rates (%) 1 yr. 2 yrs. 3 yrs 4 yrs. 5 yrs. 7 yrs. 10 yrs. 15 yrs. AAA 0.00 0.00 0.07 0.15 0.24 0.66 1.40 1.40 AA 0.00 0.02 0.12 0.25 0.43 0.89 1.29 1.48 A 0.06 0.16 0.27 0.44 0.67 1.12 2.17 3.00 BBB 0.18 0.44 0.72 1.27 1.78 2.99 4.34 4.70 BB 1.06 3.48 6.12 8.68 10.97 14.46 17.73 19.91 B 5.20 11.00 15.95 19.40 21.88 25.14 29.02 30.65 CCC 19.79 26.92 31.63 35.97 40.15 42.64 45.10 45.10 5.4. Bond Based Approach In this method, the expected loss from defaults is determined utilizing the spread of the bond yields over risk free Treasuries. The assumption in this method is that the premium paid over risk free Treasuries is the entire compensation for the expected