Lesson 2 of 7 · 14 min

Expected loss: POD × LGD

Expected loss is the probability that a borrower defaults times how much you lose if it does, and a fairly priced credit spread should at least cover it.

In short

  • Probability of default (POD): the chance the issuer misses a full and timely payment, usually per year and assuming no earlier default.
  • Expected exposure (EE) or exposure at default (EAD): the claim at default, usually face value + accrued interest − market value of collateral.
  • Recovery rate (RR): the share of the claim recovered. Loss severity = 1 − RR.
  • Loss given default: LGD=EE×(1−RR)\text{LGD} = \text{EE} \times (1 - \text{RR}). Expected loss: EL=POD×LGD\text{EL} = \text{POD} \times \text{LGD}.
  • Approximation: credit spread ≈ POD × LGD. Spread above EL → more than fairly compensated; below → less than fairly compensated.

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Expected loss: POD × LGD · Credit Risk · CheapMocks