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Credit Risk Measurement In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms, Third Edition by Linda Allen, Anthony Saunders

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CHAPTER 7
A Critical Parameter: Loss Given Default

INTRODUCTION

As discussed in Chapter 5, the loss given default (LGD) is a critical parameter used together with the probability of default (PD) to estimate expected credit losses, calculated as PD times LGD. The LGD can be defined as one minus the recovery rate (RR) on defaulted debt instruments. Despite its importance in credit risk measurement, LGD estimation is less developed than PD modeling. In this chapter, we describe how some of the credit risk models described in earlier chapters estimate LGD.

ACADEMIC MODELS OF LGD

Even if PD is relatively high, expected credit losses may be low if recovery rates are high. Thus, for example, if a loan is fully secured with marketable securities which can be sold at full value upon default, there may be no loss at all. Table 7.1 shows that even low-grade debt issues may experience low expected loss rates because LGD is substantially lower than 100 percent. That is, even if there is a default, some value is recovered (the RR is greater than zero, and LGD = 1 - RR).
Different types of debt instruments have different recovery rates. For example, more senior securities tend to have higher recovery rates than subordinated securities, all else equal. Figure 7.1 uses the recovery history included in the Moody’s KMV database to show that the highest (lowest) LGD is for preferred stock and junior subordinated bonds (industrial revenue bonds, senior secured bonds, and senior secured loans). ...

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