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Calculation of EL abd UL

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When measuring and managing credit risk, It is important to have a clear understanding of common terms such as

expected loss and unexpected loss. As stated in Credit Risk Assessment, credit risk is defined as the potential that a

bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. This article will

explain the calculations for expected loss (EL) and unexpected loss (UL), for both an individual asset and for a

portfolio. Additionally, risk contribution (RC) will be defined.

Terminology

Probability of Default (PD) is the likelihood that a loan will not be repaid and will fall

into default. It must be calculated for each borrower. The credit history of the borrower

and the nature of the investment must be taken into consideration when calculating PD.

External ratings agencies such as Standard & Poors or Moodys may be used to get a PD;

however, banks can also use internal rating methods. PD can range from 0% to 100%. If

a borrower has 15% PD it is considered a less risky company vs. a company with a 30%

PD.

Adjusted Exposure (AE) is equal to outstanding loan amount (OS) plus the percentage

of unused loan commitment (COM) drawn-down by the borrower; known as the usage

given default (UGD). AE is calculated as follows:

AE = OS + (COM OS) * (UGD)

Recovery Rate (RR) the proportion of a bad debt that can be recovered.

Loss Given Default (LGD) the credit loss incurred if an obligor of the bank defaults. LGD = 1- RR

Expected Loss (EL) referring back to Expected Loss Calculation, EL is the loss that can be incurred

as a result of lending to a company that may default. It is the average loss in value over a specified period.

Unexpected Loss (UL) it is known as the variation in expected loss. UL is typically larger than EL

but they are both equal to zero when PD is zero.

EL for a single asset is calculated by using the following formula:

EL = AE * LGD * EDF

To calculate EL for a portfolio we must add the expected losses of the individual assets; formula below:

ELP = ELi

Unexpected Loss (UL)

UL for a single asset is calculated by using the following formula:

UL = AE * SQRT [(EDF * LGD) + (LGD * EDF)]

To calculate the UL for a portfolio, we need to use a more complex formula. Below is the formula for a 2 asset

portfolio:

ULP = SQRT [ULi + ULj + 2 (i,j) (ULi) (ULj)]

Note: The UL of the portfolio will be less than the sum of the ULs for the individual assets due to diversification

benefits.

Risk Contribution

Each asset in a portfolio contributes a portion of its UL to the portfolio UL; known as risk contribution (RC). In

other words, it is the incremental risk that the exposure of a single asset contributes to the total risk of the portfolio.

The formula for calculating the RC of asset i and j for a two asset portfolio is illustrated below:

RCi = ULi * [ULi + (i,j) * (ULj) / ULp]

RCj = ULj * [ULj + (i,j) * (ULi) / ULp]

If we take the sum of RCi + RCj we will get the same value as the unexpected loss on the portfolio.

Correlation () plays an important role in measuring the potential UL in the portfolio. If correlation between the

assets increases, the potential UL will increase.

Sources:

Lending institutions need to understand the loss that can be incurred as a result of lending to a

company that may default; this is known as expected loss (EL). EL can be expressed as a

simple formula:

EL = PD * LGD * EAD

The total exposure to credit risk is the amount that the borrower owes to the lending institution at

the time of default; the exposure at default (EAD). Generally, EAD will not be larger than the

borrowing facility.

PD & LGD are risk metrics employed in the measurement and management of credit risk. The

metrics are used to calculate EL.

The probability of default (PD) is the likelihood that a loan will not be repaid and will fall into

default. It must be calculated for each borrower. The credit history of the borrower and the nature

of the investment must be taken into consideration when calculating PD. External ratings

agencies such as Standard and Poors or Moodys may be used to get a PD; however, banks can

also use internal rating methods. PD can range from 0% to 100%. If a borrower has 50% PD it is

considered a less risky company vs. a company with an 80% PD. For example:

A borrower (Company X) takes out a loan from Bank ABC for $10 million (EAD). Company X

pledges $3 million collateral against this loan (for simplicity, lets say the collateral is cash). The

Companys PD is determined by analyzing their credit risk aspects (evaluate the financial health

of the borrower, taking into account economic trends, borrower relationship with the bank, etc.)

For Company X, lets say the PD is 0.99. This means that the Company is extremely risky; the

probability of them defaulting on the loan is 99%.

Loss given default (LGD) is the fractional loss due to default. Continuing from the previous

example:

If Company X defaults (is unable to pay back the $10 million to Bank ABC), the Bank will be

able to recover $3 million (this is the cash-secured collateral).

So, how do we calculate the actual loss given default (LGD)?

The Recovery Rate (RR) is defined as the proportion of a bad debt that can be recovered. It is

calculated as:

RR = Value of Collateral/Value of the Loan

Back to our example, the recovery rate for Bank ABC = $3 million/ $10 million = 30%

So % LGD= 1- 0.30 = 0.70 or 70%.

$ LGD= 70% of a $10 million (EAD) loan is equal to $7 million.

$ LGD = $7 million

Expected Loss (EL) is what a bank can expect to lose in the case that their borrower defaults. It

is calculated below:

EL = PD * LGD * EAD

EL= 0.99* 70% * $10 million

EL = $6.93 million

Bank ABC can expect to lose $6.93 million.

Sources:

Financial Risk Manager Handbook: (Fifth Edition) Philippe Jorion Introduction to Credit Risk

(pg 434)

Wharton: What Do We Know About Loss Given Default? Til Schuermann

http://fic.wharton.upenn.edu/fic/papers/04/0401.pdf

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