Overview
A fairly common question to ask to assess credit risk is to ask what the average default rate is. From a mathematical perspective, the probability of default of a loan is well approximated by the average. (see estimation)
Average Default Rate
The average default rate is just an average rate of default for the given time frame, in this case, monthly. That is, it is a number that represents the probability of a loan defaulting in a given month.
Each record in the monthly snapshot represents a one month observation of a loan. The average default rate is just the number of defaults divided by the total number of observations.
Average Default Rate by Score
In our loan example, each loan is assigned a credit score. (see credit scoring) In addition to computing an average default rate, it is useful to compute an average default rate per score. If the scores are actually reflective of creditworthiness, we should see lower rated loans having a higher default rate.
Next Step
After computing the average loan default rate, we construct a statistical confidence interval to assess how
confident we can be that the average represents the statistical mean.