Expected Loss

The expected loss (EL)

is the amount that an institution expects to lose on a credit exposure over a given time horizon.

EL = PD x LGD x EAD xM

If we ignore correlation between the LGD variable, the EAD variable and the default event, the
expected loss for a portfolio is the sum of the individual expected losses.

What Does Default Probability Mean?

The degree of likelihood that the borrower of a loan or debt will not be able to make the
necessary scheduled repayments. Should the borrower be unable to pay, they are then said to be
in default of the debt, at which point the lenders of the debt have legal avenues to attempt
obtaining at least partial repayment.

Generally speaking, the higher the default probability a lender estimates a borrower to have, the
higher the interest rate the lender will charge the borrower (as compensation for bearing higher
default risk).

Probability of Default:

It is the assessment of the likelihood of default of the borrower over one year.Expressed as a %,
and counterparty specific.(PD)

Loss Given Default:

ItIs the assessment of the loss incurred on a facility at default of a counterparty. Expressed as a
%, and transaction specific.(LGD)

Exposure at Default:

Expected gross exposure of the facility upon default of the obligor. Expressed in amounts, and
transaction specific.(EAD)

M = Effective Maturity = Sum of (time × future cash flow)

Sum of future cash flows

 Formulas of four components

PD = Probability of Default = Number of defaults during last 12 months

Number of counterparties 12 months ago

LGD = Loss Given Default = Losses incurred after default during last 5 or 7 years

Total outstanding amount at default

EAD = Exposure At default = Total outstanding amount+CCFX Underdrawn amount

M = Effective Maturity = Sum of (time × future cash flow)

Sum of future cash flows

Example In percentage
EL = PD x LGD x EAD Xm

We can calcukate expected loss if probability default is 0.07% , lgd ia 39.5% and ead
expected that 2.8 million for 2.5 years then we can calculate expected loss as given
below.

Expected Loss(£) / (%)= Probability of Default (%) X LGD % X EAD (£) x M

£784 = 0.07% X 39.5 % X 2.8M X 2.5 YEARS

0.028%