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What is loss given default?

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The recovery rate (RR) is the percentage of a defaulted financing that a creditor receives in final settlement of its claims on its defaulted claims (lease, loan), it comprising the expected cash flows from the realization of collateral and is the reciprocal of the loss given default (1 − LGD).  The proportion of a defaulted debt that a creditor can recover depends largely on whether it is bank lending, leasing or a marketable instrument (e.g., bond) as well as the type of asset being financed.

3 Key Factors in Bond Value Recovery
   1.   Price at initial credit event – predictive of LGD.
   2.   Market value of instrument at the resolution of distress.
   3.   Actual cash flows occurring during the resolution process.

Loss given default (LGD) is the percentage of a defaulted exposure that is expected to be lost and charged off if default occurs, it measuring the loss severity on defaulted obligations and is the reciprocal of the recovery rate (1 − recovery rate).  At the time of default of a financial asset, LGD is essentially the difference between its unamortized balance (UAB), or net book value (NBV), and the asset’s fair market value (FMV):

LGD%= EAD − E(FMV)/EAD

Therefore, at any given point during the term of a loan or other financial asset, its expected loss at default (EL) is the contract’s probability of default (PD) times its loss given default (LGD) times its unamortized balance (UAB):

EL = PD x LGD x UAB

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