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CFA Level I Exam · Credit Analysis for Corporate Issuers

Credit Risk and Its Components: PD, LGD and Expected Loss

Updated 7 October 2026 · Fact-checked

Credit risk is the risk that a borrower fails to pay what it owes on time and in full. It has two parts: the probability of default and the loss severity if default happens. Expected loss = probability of default × loss given default, where LGD = exposure × (1 − recovery rate).

Understand Credit Risk and Components of Credit Risk

Credit risk is the risk of loss because a borrower does not make a promised payment on time and in full. A bondholder lends money. If the issuer cannot pay, the bondholder loses some or all of the expected cash flows.

Credit risk has two components. The first is default probability (also called probability of default, PD): how likely the borrower is to default over a given period. The second is loss severity, also called loss given default (LGD): how much you lose if default happens. These are different questions. A borrower can be very likely to default but leave you with a small loss if the debt is well secured. Another can rarely default, but you lose almost everything if it does.

Loss severity depends on the recovery rate, the percentage of the amount owed that you get back after default. LGD as a percentage = 1 − recovery rate. Recovery depends on the claim's seniority and on collateral. Senior secured debt usually recovers more than subordinated unsecured debt.

Multiply the two parts and you get expected loss = PD × LGD. This is an average, not a forecast of what will happen. In one default you lose far more than the expected loss. In no default you lose nothing. Expected loss is what a lender should price in through the yield.

Credit ratings from agencies summarise credit risk. Investment grade is BBB- or higher at S&P and Fitch (Baa3 or higher at Moody's). Below that is high yield. Ratings are opinions on creditworthiness, mainly default risk, and some also reflect recovery. They are not guarantees and can lag market events.

Key formulas to remember

Expected loss
EL = PD × LGD
PD is the probability of default over the period. LGD is the loss in money or as a percentage of exposure.
Loss given default
LGD = Exposure × (1 − Recovery rate)
Use LGD% = 1 − recovery rate when exposure is 100%.
Expected loss in money
EL = PD × Exposure × (1 − Recovery rate)
Combines the two formulas above. Exposure is the amount owed at default.
Recovery rate
Recovery rate = 1 − LGD%
Recovery is the share of the claim you get back, not of the price paid.
Credit risk components
Credit risk = default probability and loss severity
Probability of default is the likelihood of default. Loss severity is the size of loss if it happens.

How to solve Credit Risk and Components of Credit Risk questions

Use this method for any question on credit risk components, expected loss or ratings.

  1. 1Identify what is asked: PD, LGD, recovery rate, expected loss or a concept.
  2. 2Write down the given figures and check whether each is a probability, a loss percentage or a recovery percentage.
  3. 3Convert recovery to loss if needed: LGD% = 1 − recovery rate.
  4. 4Find the exposure in currency terms. Multiply by LGD% to get loss given default in money.
  5. 5Multiply by PD to get expected loss. Make sure PD covers the same period as the question.
  6. 6For concept questions, split the statement into likelihood (PD) and size of loss (LGD). Match each to the right driver, such as rating for PD and seniority or collateral for LGD.
  7. 7Check that the answer is plausible: expected loss must not exceed the LGD amount (it is smaller whenever PD < 100%).
  8. 8Pick the option that matches and eliminate the two that mix up recovery and loss.

Quickest way: PD × (1 − recovery) shortcut

When to use it: Use for any numeric expected loss question where you are given PD and recovery rate.

  1. Compute 1 − recovery rate first.
  2. Multiply by PD as a decimal.
  3. Multiply by exposure if an amount is asked.
  4. Scan the three options. Wrong ones usually use recovery instead of loss, or leave out PD.

Common mistakes in Credit Risk and Components of Credit Risk

  • Using the recovery rate as the loss severity.

    Both are percentages of the claim and the question may give only one.

    Fix: Always compute LGD% = 1 − recovery rate before multiplying by PD.

  • Treating a high rating as meaning low loss severity.

    Ratings are mostly seen as a single quality score.

    Fix: Remember ratings mainly address default probability. Loss severity depends on seniority, collateral and the recovery outlook.

  • Confusing expected loss with the loss that will occur.

    The word expected sounds like a forecast.

    Fix: Expected loss is a probability-weighted average. Actual loss is either zero or a large amount.

  • Using a PD for the wrong period.

    Questions may give an annual PD but a multi-year horizon.

    Fix: Check the horizon. Use the PD stated for the same period as the loss you are asked for.

  • Multiplying PD by the full exposure and ignoring recovery.

    Students rush and skip the second component.

    Fix: Credit risk has two parts. Always include recovery unless the question states zero recovery.

Worked examples

Example 1

A bond investor holds €2,000,000 of senior unsecured bonds. The one-year probability of default is 2%. The expected recovery rate in default is 40%. What is the expected loss? Options: A. €16,000 B. €24,000 C. €40,000

Show the solution
  1. LGD% = 1 − 0.40 = 0.60.
  2. Loss given default = €2,000,000 × 0.60 = €1,200,000.
  3. Expected loss = 0.02 × €1,200,000 = €24,000.
  4. Option A (€16,000) is PD × exposure × recovery rate (0.02 × 2,000,000 × 0.40), which uses the recovery rate instead of 1 − recovery. Option C (€40,000) is PD × exposure, ignoring recovery.

Answer: B. €24,000

Example 2

Which statement about credit risk is most accurate? A. Loss given default depends only on the probability that the issuer defaults. B. Two bonds from the same issuer can have different loss severity because of seniority. C. A higher recovery rate increases the loss severity.

Show the solution
  1. Statement A confuses the two components. LGD is the size of loss, not the probability of default.
  2. Statement C reverses the relationship. LGD% = 1 − recovery rate, so higher recovery lowers loss severity.
  3. Statement B is correct. Same issuer means the same default probability, but senior debt usually recovers more than subordinated debt, so loss severity differs.

Answer: B

Exam tips

  • Questions are three-option items. For numeric ones, the wrong options often reflect a missed step, so compute carefully and compare.
  • Expect concept items that split credit risk into probability of default and loss severity. Link PD to rating and LGD to seniority and collateral.
  • Do the 1 − recovery step first and write it down. It is the most common lost mark.
  • Remember that expected loss is a probability-weighted average, not what you will actually lose.
  • Numerical options go from smallest to largest, so a quick estimate can remove one option.

Practice questions from Credit Analysis for Corporate Issuers

Credit Risk and Components of Credit Risk in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Risk and Components of Credit Risk: frequently asked questions

What is the difference between default risk and loss severity?

Default risk is the probability that the borrower fails to pay. Loss severity is how much you lose if that happens. Credit risk combines both.

How do you calculate expected loss in credit analysis?

Multiply the probability of default by the loss given default. With recovery given, LGD = exposure × (1 − recovery rate). So EL = PD × exposure × (1 − recovery rate).

What is the relationship between recovery rate and loss given default?

They are complements as percentages of the claim. LGD% = 1 − recovery rate. A higher recovery rate means a lower loss given default.

Do credit ratings measure both PD and LGD?

Ratings mainly express an opinion on creditworthiness, chiefly default risk. Some ratings also reflect expected recovery, but you should treat PD and LGD as separate ideas on the exam.