POTENTIAL LOSS AND ITS MEASUREMENT

Downside risk is an estimation of a security's potential loss in value if market

conditions precipitate a decline in that security's price. Depending on the measure
used, downside risk explains a worst-case scenario for an investment and indicates
how much the investor stands to lose. Downside risk measures are considered one-
sided tests since the potential for profit is not considered.

Investors, traders, and analysts use a variety of technical and

fundamental metrics to estimate the likelihood that an investment's value will
decline, including historical performance and standard deviation calculations. In
general, many investments that have a greater potential for downside risk also have
an increased potential for positive rewards.

TYPES OF POTENTIAL LOSSES

1. Expected loss
2. Unexpected loss
3. Exceptional loss

Expected loss: The expected or EL is a statistical estimate of the average losses.

The average loss is often calculated for credit risk because it represents the
statistical mean of losses across a portfolio and over all possible outcomes.

The actual losses will usually differ from expected loss, since it will be higher or
lower. Expected losses are netted out of revenues by making provisions to hedge
the losses.

The expected loss is given by

EL= EAD ×PD ×LGD

EAD is the Exposure at default (EAD) is the total value a bank is exposed to
when a loan defaults. Using the internal ratings-based (IRB) approach, financial
institutions calculate their risk. Banks often use internal risk management default
models to estimate respective EAD systems. Outside of the banking industry, EAD
is known as credit exposure.

Where PD is the probability of default (PD). It provides an estimate of the

likelihood that a borrower will be unable to meet its debt obligations.

LGD is the loss given default (LGD) is an important calculation for financial
institutions projecting out their expected losses due to borrowers defaulting on
loans and LGD is the share of loan (asset) that is lost if a borrower defaults.

LGD= 1- Recovery Rate (RR) also called recovery ratio

Illustration

A defaulted loan in the books of a Bank to a BB rated borrower gives the

following details

1. Balance outstanding at the time of default =1000000

2. Amount received after two years = 750000
3. Legal cost received in recovery= 75000

Calculate the LGD of the facility assume 8% discount rate

LGD= 1-Recovery Rate

Recovery Rate= Recovery Amount- Expenses to recover loan amount (legal

Cost (1+r) n/outstanding amount of loan

RR= 750000-75000/ (1+0.08)2/1000000=0.578

LGD=1-0.578=0.422= 42.2%
Illustration

Suppose Bank has given loan to the borrower whose Rating is A+ and the
loan amount is 60000 probability of default is 0.05 and the loss given default is
25%, calculate the expected loss i. e expected loss due to the credit risk.

Sol. EL= EAD× PD × LGD

60000×0.05×25%=750

Unexpected loss: The unexpected loss or UL is the maximum loss that will be
exceeded only in a limited given fraction of all cases. The unexpected loss is the
VaR (Value at Risk).

UL= EAD× √ (PD× σ2LGD+LGD2× σ2PD)

Whereas EAD= Exposure at default

PD= Probability at default

σLGD= Loss Given default Standard Deviation

σPD= Probability Default Standard Deviation

Illustration:

J&K bank has recently disbursed a loan amount of 200000 out of which
160000 is outstanding according to rating agency the beneficiary has1% of
probability Default and incase that happens given loss default (loss Rate) is
30% and the probability default and given loss default( loss rate) have
standard deviation of 6% and 20% respectively. Calculate the unexpected loss
for the bank out of this loan disbursement

Sol. EAD= 160000

PD= 1%

LGD= 30%

σPD= 6%

σLGD=20%

Formula for unexpected loss is

UL= EAD× √ (PD× σ2LGD+LGD2× σ2PD)

= 160000×√0.01×0.22+0.32×0.062=

=160000×√0.01×0.04+0.09×0.0036

=160000×√0.0004+0.000324

=160000×√0.000724

UL=160000×0.0269=4304

Exceptional Loss: The exceptional losses are those that occur beyond the
maximum unexpected loss. Their likelihood of occurrence is normally very low. In
practice the exceptional losses are obviously difficult to value owing to their very
low probability of occurrence.

EXPECTED RETURN AND STANDARD DEVIATION OF RETURN

Expected Return is given by the formula

E(R) = ∑RP

Where E(R) = Expected Return on stock

P= Probability that the state of occurs

Standard Deviation of Return

σ2 = ∑P(R-E(R)) 2

Numerical
Return P×R R-E(R) (R-E(R))2 P(R-E(R))2
Sate of Probability
(%)
economy of (R)
occurrence
(P)

Boom 0.30 16 4.8 16- 20.25 6.075

11.5=4.5
Normal 0.50 11 5.5 11-11.5=- 0.25 0.125
0.5
Recession 0.20 6 1.2 6-11.5=- 30.25 6.05
5.5
Total E(R)=
11.5 ∑P(R-
E(R))2=12.25

σ2=12.25, σ= √12.25=3.5%