The quantification of credit risk, assigning measurable and comparable numbers to the likelihood of default or spread risk, is a major frontier in modern finance. The factors that affect credit risk range from borrower-specific criteria, such as debt ratios, to market-wide considerations such as economic growth. The idea is that liabilities can be objectively valued and predicted to help protect against financial loss.
There are several major variables to consider: the financial health of the borrower; the severity of the consequences of default for the borrower and the creditor; the size of the credit extension; historical trends in default rates; and a variety of macroeconomic considerations. Among all of the possible factors, three are consistently identified as having a stronger correlative relationship to credit risk.
Probability of Default
The probability of default, sometimes abbreviated as POD or PD, expresses the likelihood the borrower will not maintain the financial capability to make scheduled debt payments. For individual borrowers, default probability is most represented as a combination of two factors: debt-to-income ratio and credit score. For entities that issue debt instruments, such as corporate bonds, the probability of default is estimated by credit rating agencies. Generally speaking, higher PODs correspond with higher interest rates and higher required down payments on a loan. Borrowers can help share default risk by pledging collateral against a loan.
Loss Given Default
Imagine two borrowers with identical credit scores and identical debt-to-income ratios. The first person takes out a $5,000 loan and the second takes out a $500,000 loan. Even if the second individual has 100 times the income of the first, his or her loan represents a greater risk. This is because the lender stands to lose a lot more money in the event of default on a $500,000 loan. This principle underlies the loss given default, or LGD, factor in quantifying risk.
Loss given default seems like a straightforward concept, but there is actually no universally accepted method of calculating LGD. Most lenders do not calculate LGD for each separate loan; instead, they review an entire portfolio of loans and estimate total exposure to loss. Several factors can influence LGD, including any collateral on the loan and the legal ability to pursue the defaulted funds through bankruptcy proceedings.
Exposure at Default
Similar in concept to LGD, exposure at default, or EAD, is an assessment of the total loss exposure a lender is exposed to at any point in time. Even though EAD is almost always used in reference to a financial institution, the total exposure is an important concept for any individual or entity with extended credit. The formula for EAD is normally calculated by multiplying each credit obligation by a certain percentage adjusted for specific details of each obligation.