, PLEASE USE THIS DOCUMENT AS A GUIDE TO ANSWER YOUR ASSIGNMENT
Question 1
A) Explain the two most important drivers of credit risk and how those relate to the probability
of default (PD).
The two most important drivers of credit risk are Loss Given Default (LGD) and Exposure at Default
(EAD). These factors significantly influence the potential loss a lender may incur if a borrower
defaults and are essential components in the calculation of credit risk.
Loss Given Default (LGD):
LGD represents the proportion of the exposure that is lost by the lender if a borrower defaults. It
reflects the severity of the loss and takes into account recoveries from collateral or other forms of
credit enhancement. LGD is typically expressed as a percentage and varies depending on the type of
credit facility, the collateral involved, and market conditions. A higher LGD indicates that the lender
stands to lose more if default occurs.
Exposure at Default (EAD):
EAD is the total value a lender is exposed to at the time of default. For credit facilities like loans or
revolving credit lines, this includes the outstanding balance and any amounts that the borrower is
likely to draw before default. EAD determines the total potential exposure that could be lost if the
borrower fails to meet their obligations.
Relation to Probability of Default (PD)
PD is the likelihood that a borrower will default on their debt obligations within a specified period,
usually one year. It reflects the creditworthiness of the borrower and is often based on internal credit
assessments or external credit ratings.
While PD indicates the chance of a default occurring, EAD and LGD determine the size of the loss if
that default happens. Together, these three components form the foundation of the Expected Loss
(EL) calculation, which is expressed as:
EL = PD × EAD × LGD
This equation shows that credit risk depends not only on the likelihood of default (PD) but also on
how much is at risk (EAD) and how much would be lost if default occurs (LGD). Therefore, EAD
and LGD are considered the most important drivers of credit risk because they directly affect the
potential magnitude of financial loss.
Question 1
A) Explain the two most important drivers of credit risk and how those relate to the probability
of default (PD).
The two most important drivers of credit risk are Loss Given Default (LGD) and Exposure at Default
(EAD). These factors significantly influence the potential loss a lender may incur if a borrower
defaults and are essential components in the calculation of credit risk.
Loss Given Default (LGD):
LGD represents the proportion of the exposure that is lost by the lender if a borrower defaults. It
reflects the severity of the loss and takes into account recoveries from collateral or other forms of
credit enhancement. LGD is typically expressed as a percentage and varies depending on the type of
credit facility, the collateral involved, and market conditions. A higher LGD indicates that the lender
stands to lose more if default occurs.
Exposure at Default (EAD):
EAD is the total value a lender is exposed to at the time of default. For credit facilities like loans or
revolving credit lines, this includes the outstanding balance and any amounts that the borrower is
likely to draw before default. EAD determines the total potential exposure that could be lost if the
borrower fails to meet their obligations.
Relation to Probability of Default (PD)
PD is the likelihood that a borrower will default on their debt obligations within a specified period,
usually one year. It reflects the creditworthiness of the borrower and is often based on internal credit
assessments or external credit ratings.
While PD indicates the chance of a default occurring, EAD and LGD determine the size of the loss if
that default happens. Together, these three components form the foundation of the Expected Loss
(EL) calculation, which is expressed as:
EL = PD × EAD × LGD
This equation shows that credit risk depends not only on the likelihood of default (PD) but also on
how much is at risk (EAD) and how much would be lost if default occurs (LGD). Therefore, EAD
and LGD are considered the most important drivers of credit risk because they directly affect the
potential magnitude of financial loss.
