Credit Risk Modeling Using Excel and VBA with DVD

5

Prediction of Loss Given Default

The preceding chapters covered methods for estimating the probability of default. Although such estimates are crucial for assessing the risk incurred by lenders, they do not give a complete picture. Lenders also need to assess the magnitude of losses that arise in the event of default.

In the literature, loss magnitude is usually expressed as a percentage loss rate: the loss given default (LGD). If a lender has a claim of 100 but receives only 40, the LGD would be (100 – 40)/100 = 60%. Alternatively, we can capture the same information through recovery rates. The recovery rate is obtained by 1 – LGD. To complete the terminology, note that a lender's claim is usually called exposure at default (EAD).

Bankruptcy procedures can take years to resolve, a fact that creates measurement problems. In the above example, it would make a difference whether the lender receives 40 one month after default, two years after default or in several installments over the next two years. Two common ways of addressing this issue are the following:

• Determine the discounted value of cash flows that a lender receives until the end of the bankruptcy procedure and relate it to the claim.
• Take secondary market prices of debt instruments. A frequent choice is to take prices 30 days after the default event and relate them to the face value of the instrument.

The practical advantage of the second approach is that loss given default can be measured shortly after default and ...