Exposure to default and loss given default

Two important risk drivers in credit risk are exposure risk (measured by exposure at default (EAD) and loss given default (LGD) or recovery rate (RR)). The former is related to the fact that the amount due at default could not be known with certainty. This is the case, for example, of revolving credit lines, where the borrower could increase his/her credit usage before default. Several measures can be used to assess exposure risk, with CCF (credit conversion factor) being the most widely used one. Empirical analyses have shown that CCFs are mainly impacted by the borrower’s rating, the time-to-default, and the state of the economic cycle. LGDs and recovery rates can be measured in several ways: whereas market LGDs are mostly based on postdefault prices (and therefore require the exposures to be traded on a secondary market), in workout LGDs it is required to record and discount all actual recovery flows occurring after the default. The main drivers of LGD are the debt seniority, the borrower’s industry and liabilities mix, and the presence of collateral. Recently, LGDs have been found to increase together with PDs: measures of expected and unexpected loss can prove to be severely underestimated if such a correlation is ignored.