Credit Risk Fundamentals › The Credit Risk Framework

Credit risk manifests in several forms, each requiring your careful attention. Default risk is the most severe form: a borrower fails to make required payments, triggering legal remedies and potential losses for creditors. This is the ultimate credit event that the entire framework is designed to assess. Credit migration risk occurs when a borrower's credit quality deteriorates, increasing the likelihood of future default and reducing the value of existing exposures. Even without an actual default, a downgrade from investment grade to speculative grade can cause significant mark-to-market losses for bondholders. Spread risk, which we touched on when discussing CDS pricing, reflects changes in credit spreads even without actual default or rating changes. These spread movements reflect the market's evolving assessment of creditworthiness and can create substantial gains or losses for holders of credit-sensitive instruments.

The fundamental equation of credit risk measurement combines three components into a single expression for expected credit losses:

where:

• $\text{Expected Loss}$: the average loss anticipated over the time horizon
• $\text{PD}$: Probability of Default, the likelihood that the borrower will default within a given time horizon
• $\text{LGD}$: Loss Given Default, the fraction of exposure lost if default occurs
• $\text{EAD}$: Exposure at Default, the amount owed at the moment of default

This deceptively simple formula answers three core questions. First, how likely is it that this borrower will fail to meet their obligations? Second, if they do default, how much of our exposure will we lose after recovery efforts? Third, at the moment of default, how much will we have at stake? This framework is modular: each component can be modeled separately, yet they combine to produce a single, actionable measure of expected credit loss.

Each component requires careful estimation and carries its own sources of uncertainty. Probability of Default depends on the borrower's financial health, industry conditions, and macroeconomic factors. Loss Given Default varies with collateral quality, seniority in the capital structure, and the economic environment at the time of default. Exposure at Default can change over time as borrowers draw on credit lines or as derivative exposures fluctuate with market conditions. We'll examine each in depth before bringing them together to see how the complete framework operates in practice.