Loss Given Default

When a portfolio manager lends to a company by holding its bonds, credit research boils down to three questions:

1. How likely is the borrower to default? — probability of default (PD).
2. How much is at stake if it does? — exposure at default (EAD): principal and interest outstanding, the maximum the investor can lose.
3. What loss should be expected? — which the XXI-B workbook calls Loss Given Default (LGD).

The workbook's definition: LGD is an estimation of expected loss, in money terms, due to the borrower defaulting, calculated by multiplying probability of default by exposure at default.

The workbook lists three components of measuring credit risk:

Portfolio managers do not rely on ratings alone. Their own credit research revolves around the four Cs — Capacity, Collateral, Covenants and Capital — which helps them arrive at probability of default and loss given default.

The workbook also names the challenges: sharp deterioration in credit quality that ratings do not reflect in time, poor diversification (the Indian corporate bond market is dominated by the financial sector), and higher tail risk than models assume.

As defined in the XXI-B workbook:

LGD (₹) = Probability of default × Exposure at default

Exposure at default = principal outstanding + interest outstanding

Illustrative figures. A PMS holds non-convertible debentures of an NBFC.

LGD (workbook definition) = 2% × ₹10.8 crore = ₹21.6 lakh

That ₹21.6 lakh is the loss the manager should expect to bear, on average, for carrying this exposure. The workbook's point is that the manager must check whether the bond's yield prices that expected credit loss.

Now a rating agency downgrades the NBFC and bid-ask spreads on its paper widen sharply — both signs the workbook says point to a highly probable default. The credit team raises PD to 15%:

LGD = 15% × ₹10.8 crore = ₹1.62 crore

The expected loss has multiplied by 7.5 without any change in the exposure. The manager now acts under the risk framework — tolerate, mitigate, transfer or terminate.

Chapter 17 (Risk), section 17.4.5, sets out the three components of credit risk measurement and the four Cs, and Chapter 19 (Fixed Income Portfolio Management Strategies), section 19.3.2, repeats the four Cs and the PD/LGD outputs of credit analysis. A Chapter 17 matching question pairs Loss Given Default with "expected money loss, calculated as PD × EAD".

• Answer by the workbook's definition. In this paper, LGD is PD × EAD, an expected loss in money terms.
• Outside this workbook, the term is commonly used differently — for the share of the exposure lost once default has actually happened, with PD × EAD × that loss rate called expected loss. Recognise the textbook usage if it appears, but the XXI-B answer is the workbook's.
• EAD is the maximum loss; LGD is the expected loss. Do not swap them.
• The four Cs are Capacity, Collateral, Covenants and Capital — not Character, which some other frameworks include.
• Sovereign bonds are free from credit risk in the domestic market (Chapter 19), though Chapter 17 adds that government-backed bonds are "not completely credit risk free".