Loss Given Default and Exposure at Default

PD, LGD and EAD describe different components of credit risk. PD estimates the probability of a defined default event over a horizon. LGD estimates the loss fraction if default occurs, relative to the exposure; collateral, guarantees, recoveries, costs and timing can affect that estimate. EAD estimates the gross amount of the facility when default occurs. For an on-balance-sheet loan it relates to the drawn balance; for a revolving or off-balance-sheet facility, additional drawdowns can make EAD differ from today’s balance. A simplified expected-loss calculation is PD × LGD × EAD when the inputs are aligned to the same exposure, default definition and horizon. PD and LGD are ratios; EAD is an amount of currency under the Basel IRB framework. The product is an estimate, not a complete accounting provision or capital calculation. Regulatory capital formulas include additional conditions, and accounting standards can define expected credit loss differently. Do not confuse the simplified intuition with a bank’s official reporting method. Estimating LGD requires data on recoveries and costs after default, including how long collection takes and how collateral is valued. EAD models need data about balances and additional usage before default. Basel’s IRB requirements address representative observations, long-run experience and model validation for institutions using that approach. Changes in product terms, collections policy or economic conditions can alter the estimates. Document data, assumptions and uncertainty, and review each parameter separately before combining them in a portfolio measure.