Default Probability Skew

Default probability skew describes the phenomenon where the market prices of credit instruments reflect an uneven distribution of default risk compared to historical or theoretical models. It often manifests as a "smile" or "skew" in implied default probabilities across different tranches, similar to the volatility skew seen in equity options.

This skew indicates that the market is pricing in a higher probability of extreme events ⎊ such as mass defaults ⎊ than a standard Gaussian model would suggest. Traders must analyze this skew to identify mispriced tranches or to determine if the market is overestimating the risk of systemic failure.

The skew is a dynamic measure that shifts with market sentiment and liquidity conditions. It serves as a vital signal for understanding how the market views the tail risk of a structured credit portfolio.