Separate expected credit loss and market compensation

Learning goals

• Calculate expected credit loss over one year.
• Explain why 60% applies to this case.
• Identify the case-specific assumption or failure mode before taking action.

Draft · approximately 55 minutes, excluding further revision.

Shared case and decision context

A one-year unsecured exposure is 10 million. Default probability is 2% and recovery conditional on default is 40%. Ignore discounting and changing exposure. A traded credit spread also contains liquidity and risk premiums.

Economic or professional mechanism

Expected loss combines probability, exposure and loss severity on a consistent horizon. Structural models link default to the firm’s asset value and liabilities; reduced-form models specify default intensity more directly. Market-implied default probabilities use pricing assumptions and risk-neutral compensation, so they need not equal physical forecasts.

Apply, challenge and communicate

Expected loss is 120,000 and LGD 60%. Stress PD and recovery jointly because recoveries can deteriorate in downturns. Migration, concentration and liquidity can create losses even before contractual default. Do not replace a credit spread with the expected-loss percentage without considering these additional components.

Use ratings as an input rather than a substitute for analysis

Credit ratings summarize an agency’s assessment under its methodology; scores often use statistical inputs for a borrower population. Neither eliminates issuer-specific due diligence or guarantees timely recognition of deterioration. Ratings can be through-the-cycle or point-in-time in different contexts. Examine outlooks, methodologies, concentration and market signals, and avoid interpreting a letter grade as an exact default probability for every horizon.

Weight rating migration outcomes

Expected holding-period bond return can include coupon income and price changes across rating transitions, including default recovery. If next-period total values are105 with probability.9 and60 with probability.1 on an initial price100, expected value100.5 implies.5% expected return. Probabilities must include mutually exclusive exhaustive states. A downgrade loss can occur without default, and a high yield to maturity is not automatically expected realized return.

Price expected credit cash flows under a pricing measure

A simplified one-period risky payoff of100 if survival and40 if default, with risk-neutral default probability3% and risk-free rate5%, has value(.97×100+.03×40)/1.05=93.5238. Its promised yield100/P−1 is6.9246%, above5%. This illustration excludes liquidity and other effects; using a physical PD with a risk-free discount rate would not generally yield a market price without a risk adjustment.

Read a credit-spread curve

Credit spread term structure reflects default timing, recovery, risk premiums and liquidity by maturity. An upward slope can reflect higher cumulative uncertainty; an inverted curve can reflect near-term distress, but neither shape has one universal cause. Compare the same issuer, seniority, currency and contractual options across maturities. A spread inversion is not identical to inversion of the government yield curve.

Analyze collateral pools and tranche waterfalls

Securitized credit analysis studies pool quality, default correlation, prepayments, servicing, legal structure and the waterfall allocating cash and losses. A senior tranche can be protected by subordination yet remain sensitive to correlated losses and model error. Corporate credit instead centers on the operating issuer and its capital structure. Tranching redistributes losses; it does not eliminate the underlying pool’s economic losses.

Formula and assumptions

EL=EAD*PD*LGD; LGD=1−recovery

Case analysis with explicit assumptions

1. A one-year unsecured exposure is 10 million. Default probability is 2% and recovery conditional on default is 40%. Ignore discounting and changing exposure. A traded credit spread also contains liquidity and risk premiums.
2. Method: EL=EAD*PD*LGD; LGD=1−recovery
3. Case result: 120,000. Expected loss is 120,000 and LGD 60%. Stress PD and recovery jointly because recoveries can deteriorate in downturns. Migration, concentration and liquidity can create losses even before contractual default. Do not replace a credit spread with the expected-loss percentage without considering these additional components.

Errors to catch

• Do not replace the stated assumptions with an unstated shortcut. Reconcile units, timing and the claim being valued or duty being assessed.
• Hold every recovery fixed by necessity is not a defensible conclusion for these case facts.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.cfainstitute.org
• Reference · www.bis.org