Credit Risk Fundamentals › Summary

This chapter established the fundamental framework for measuring credit risk through its three core components:

Probability of Default (PD) measures the likelihood of borrower default over a specified horizon. PD can be estimated through credit ratings (providing stable, through-the-cycle assessments), market-implied approaches (extracting risk-neutral probabilities from CDS spreads), or structural models (treating equity as a call option on firm assets). The choice between through-the-cycle and point-in-time PD depends on the application.

Loss Given Default (LGD) captures the severity of loss when default occurs, typically expressed as 1 minus the recovery rate. LGD varies significantly by seniority, collateral, industry, and economic conditions. Recoveries tend to be lower precisely when default rates are high, creating procyclical credit losses.

Exposure at Default (EAD) quantifies the amount at risk when default occurs. For drawn loans, EAD is straightforward. For commitments and derivatives, EAD must account for potential drawdowns and exposure changes before default.

The expected loss formula, EL = PD × LGD × EAD, sets up loan pricing, provisioning, and portfolio risk assessment. However, unexpected loss and Credit VaR, which account for volatility around expected outcomes and default correlation, are equally important for capital allocation and risk limits.

Understanding these fundamentals prepares you for the more sophisticated credit risk modeling approaches we'll examine next, including the Merton structural model, CreditMetrics, and reduced-form intensity models.