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What is Credit Risk?
Credit risk is the risk of loss due to a borrower's inability or unwillingness to make timely payments on their debt obligations. It is the risk that a lender or investor takes on when providing credit to a borrower. Credit risk can be measured using a variety of metrics, such as credit scores, credit ratings, debt-to-income ratios, and payment history, and it is an important factor to consider when evaluating the creditworthiness of a potential borrower or investment.
What are the important metrics used in the calculation of credit risk?
Probability of default (PD), loss-given default (LGD), and exposure at default (EAD) are important metrics used in the calculation of credit risk.
The probability of default (PD) is the likelihood that a borrower will default on their debt obligations. It is typically expressed as a percentage or a decimal.
Loss-given default (LGD) is the expected loss to the lender if the borrower defaults on their debt. It is typically expressed as a percentage of the total loan amount.
Exposure at default (EAD) is the amount of money that the lender is exposed to in the event of a default. It is typically equal to the total loan amount but can be adjusted to take into account any collateral or other credit risk mitigants.
PD, LGD, and EAD are used to calculate the credit risk of a borrower or investment, as the formula of credit risk = PD x LGD x EAD. This calculation is used to determine the amount of capital that a lender or investment bank should hold to cover potential losses due to credit risk.
What is the Probability of Default?
The Probability of Default (PD) is a measure of the likelihood that a borrower will default on their debt obligations. It is an important metric used in the calculation of credit risk, as it reflects the likelihood that a lender or investor will incur a loss due to a borrower's inability or unwillingness to make timely payments on their debt.
PD is typically expressed as a percentage or a decimal and is based on the borrower's credit history, financial stability, and other factors that may affect their ability to make their debt payments. For example, a borrower with a strong credit history, stable income, and a low debt-to-income ratio may have a low PD, indicating a lower credit risk. On the other hand, a borrower with a weak credit history, unstable income, and a high debt-to-income ratio may have a higher PD, indicating a higher credit risk.
What is Loss-Given Default?
Loss-Given Default (LGD) is a measure of the expected loss to the lender if the borrower defaults on their debt. It is an important metric used in the calculation of credit risk, as it reflects the amount of money that the lender is expected to lose in the event of a default.
LGD is typically expressed as a percentage of the total loan amount and reflects the likelihood that the lender will be able to recover some or all of the loan through the sale of collateral or other means. For example, if a borrower defaults on a loan and the lender is able to recover 50% of the loan through the sale of collateral, the LGD would be 50%.
What is Exposure at Default?
Exposure at default (EAD) is a measure of the amount of money that a lender would be exposed to if a borrower defaults on their loan. It is typically calculated as the total loan amount but can be adjusted to take into account any collateral or other credit risk mitigants that may be in place. For example, if a borrower has put up collateral in the form of a mortgage on their home, the EAD would be reduced by the value of the collateral, and this is because the lender would be able to recover at least some of the money they are owed by selling the collateral.
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[Important Terminologies]
Probability of Default (PD), Loss-Given Default (LGD), Exposure at Default (EAD)
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