LO 16.6: Describe quantitative measurements and factors o f credit risk, including

LO 16.6: Describe quantitative measurements and factors o f credit risk, including probability o f default, loss given default, exposure at default, expected loss, and time horizon.
Credit risk, the likelihood that a borrower will repay a loan according to the loan agreement, and default risk, the probability that a borrower will default, are essentially the
2018 Kaplan, Inc.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
same because a default on a financial obligation almost always results in a loss to the lender. In the last decade, there have been significant changes in the financial sector. These changes, combined with regulatory changes in the industry, have resulted in a somewhat revised view of credit and default risks. Current measures used to evaluate creditworthiness are described as follows:
Probability of default (PD): The likelihood that a borrower will default is not necessarily the creditors greatest concern. A borrower may briefly default and then quickly correct the situation by making a payment, paying interest charges or penalties for missed payments. Creditors must rely on other measures of risk in addition to PD.
Loss given default (LGD): LGD represents the likely percentage loss if the borrower defaults. The severity of a default is equally as important to the creditor as the likelihood that the default would occur in the first place. If the default is brief and the creditor suffers no loss as a result, it is less of a concern than if the default is permanent and the creditor suffers significant losses. Both PD and LGD are expressed as percentages.
Exposure at default (EAD): The loss exposure may be stated as a dollar amount (e.g., the loan balance outstanding). EAD can also be stated as a percentage of the nominal amount of the loan or the maximum amount available on a credit line.
Expected loss (EL): Expected loss for a given time horizon is calculated as the product of the PD, LGD, and EAD (i.e., PD x LGD x EAD).
Time horizon: The longer the time horizon (i.e., the longer the tenor of the loan), the greater the risk to the lender and the higher the probability of default. Also, EAD and LGD change with time. The exposure (EAD) increases as the borrower draws on a credit line and falls as the loan is paid down. The LGD can also change as the terms of the loan or credit line change.
Expected loss generally depends on four variables: PD, LGD, EAD, and time horizon. A bank should also consider the correlations between various risk exposures when analyzing credit risk in a portfolio context.
Example: Calculating expected loss
Star City Bank and Trust has examined its loan portfolio over the past year. It has determined that the probability of default was 4%, adjusted for the size of the exposure. The loss given default over the period was 80%. Bank risk managers estimate that the exposure at default was 75% of the potential exposure. Calculate the expected loss given a one-year time horizon.
expected loss = 4% x 80% x 75% = 2.4%
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2018 Kaplan, Inc.
Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
Professors Note: It is straightforward to calculate PD, LGD, and EAD after the fact. As the previous example illustrates, a lender can analyze historical occurrences o f default, loss given default, and loss exposure. However, it is difficult to estimate these measures in advance. A financial institution or other nonhank lender can use historical experience to help predict future losses, but the forecast will not be perfect. Using historical mortgage loss data would have been little help in forecasting actual losses that occurred during the 20072009 financial crisis.
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