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Simple LGD example: If the client defaults, with an outstanding debt of 200,000 (EAD) and the bank is able to sell the security for a net price of 160,000 (including costs related to the repurchase), then 40,000, or 20%, of the EAD are lost - the LGD is 20%.
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
For closed-end exposures, EAD must not be lower than the current outstanding balance owed to the bank. For revolving exposures, EAD should take into account any undrawn commitments. For corporate, sovereign or bank exposures, LGD and EAD estimates should be based on a full economic cycle and must not be shorter than a period of seven years.
The key variables for (credit) risk assessment are the probability of default (PD), the loss given default (LGD) and the exposure at default (EAD).The credit conversion factor calculates the amount of a free credit line and other off-balance-sheet transactions (with the exception of derivatives) to an EAD amount [2] and is an integral part in the European banking regulation since the Basel II ...
In addition to PD models, this framework can also be used to develop PIT and TTC variants of LGD, EAD and Stress Testing models. Most PD models output PDs that are of a hybrid nature: [13] they are neither perfectly Point-In-Time (PIT) nor through-the-cycle (TTC). The long-run average of Observed Default Frequency ODF is often regarded as a TTC PD.
Banks can determine their own estimation for some components of risk measure: the probability of default (PD), loss given default (LGD), exposure at default (EAD) and effective maturity (M). For public companies, default probabilities are commonly estimated using either the "structural model" of credit risk proposed by Robert Merton (1974) or ...
where is the maturity of the longest transaction in the portfolio, is the future value of one unit of the base currency invested today at the prevailing interest rate for maturity , is the loss given default, is the time of default, () is the exposure at time , and (,) is the risk neutral probability of counterparty default between times and .
The term Foundation IRB or F-IRB is an abbreviation of foundation internal ratings-based approach, and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.