The practice of assigning quantifiable and comparable values to the chance of default risk is known as credit risk quantification, and it is a significant frontier in contemporary finance. Credit risk is influenced by a variety of variables, ranging from borrower-specific criteria to market-wide issues. The premise is that liabilities may be objectively assessed and forecasted in order to safeguard the lender from financial loss.
When evaluating credit risk, several major variables are considered: the borrower’s financial health; the severity of the consequences of a default (for both the borrower and the lender); the size of the credit extension; historical trends in default rates; and a variety of macroeconomic considerations, such as economic growth and interest rates.
- Credit risk is quantified using many elements, the most important of which are the chance of default, loss given default, and exposure at default.
- The probability of default assesses the possibility that a borrower will be unable to make timely payments.
- Loss due to default considers the loan amount, any collateral used for the loan, and the legal capacity to recover the defaulted monies if the borrower declares bankruptcy.
- The entire risk of default that a lender bears at any particular moment is measured by exposure at default.
Among all potential criteria, three have consistently been recognized as having a larger correlative connection to credit risk: default likelihood, loss given default, and default exposure.
Investopedia / Ellen Lindner
Probability of Default
The probability of default, abbreviated as POD or PD, shows the possibility that the borrower will be unable to make scheduled debt payments. Individual debtors’ default risk is best expressed by a combination of two factors: debt-to-income ratio and credit score.
Credit rating agencies assess the likelihood of default for companies and organizations that issue debt instruments such as corporate bonds. In general, greater PODs equate to higher interest rates and necessary loan down payments. Borrowers may help spread the risk of default by pledging collateral against a loan.
Loss Given Default
Consider two debtors who have equal credit ratings and debt-to-income ratios. The first borrower gets a $5,000 loan, while the second gets a $500 loan. Even if the second person has 100 times the income of the first, their loan is riskier. This is due to the lender standing to lose a lot more money in the case of a $500,000 loan default. This idea underpins the loss given default, or LGD, risk-quantification factor.
Loss given default seems to be a simple notion, however there is no commonly acknowledged technique of calculating LGD. Most lenders do not compute LGD for each individual loan; instead, they examine a whole portfolio of loans and assess overall risk exposure. LGD may be influenced by a number of circumstances, including any security on the loan and the legal power to recover the defaulted payments via bankruptcy processes.
Exposure at Default
Exposure at default, or EAD, is a concept similar to LGD in that it assesses the overall loss exposure a lender faces at any one moment. Despite the fact that EAD is typically often associated with a financial institution, total exposure is a significant notion for any person or company with extended credit.
EAD is based on the notion that risk exposure is determined by outstanding amounts that may accumulate prior to default. For example, risk exposure calculations for loans with credit limitations, such as credit cards or lines of credit, should consider not just current amounts, but also the prospective growth in account balances that might occur before the borrower defaults.
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