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CFA Level I Exam · Credit Risk

Credit Risk Basics: Default Risk and Loss Severity

Updated 7 October 2026 · Fact-checked

Credit risk is the risk of loss when a borrower fails to pay as promised. It has two parts: default risk (probability of default) and loss severity (loss given default). Expected loss = probability of default × loss given default, and LGD = 1 − recovery rate. Multiply by exposure for a currency amount.

Understand Credit Risk Basics: Default Risk and Loss Severity

Credit risk is the chance that a borrower or counterparty does not pay what it owes, in full or on time. A bondholder lends money and expects coupons and principal. If the issuer fails, the bondholder loses part of that value.

Credit risk has two separate parts. Default risk (also called probability of default, PD) is how likely the borrower is to fail to pay. Loss severity (loss given default, LGD) is how much you lose if default does happen. A firm can have a high PD but a low LGD if its debt is well secured. Another can have a low PD but a high LGD if the debt is junior and unsecured. Keep the two ideas apart.

The recovery rate is the share of the amount owed that the investor gets back after default. Loss given default is the rest: LGD = 1 − recovery rate. Recovery depends on seniority, collateral, and the value of the issuer's assets. Senior secured debt usually recovers more than subordinated unsecured debt.

Exposure at default (EAD) is the amount you stand to lose at the moment of default. For a simple bond it is the amount owed. Multiply EAD by LGD to get the loss if default happens, then by PD to get the expected loss, the average loss you should expect over the period. Expected loss is a probability-weighted average, not a forecast of what will happen to one bond.

Key formulas to remember

Expected loss
EL = PD × LGD × EAD
If the question gives LGD as a percentage of exposure, EL as a percentage is PD × LGD. Multiply by EAD for a currency amount.
Loss given default
LGD = 1 − recovery rate
LGD is a percentage of the exposure. The recovery rate is a share of the amount owed. For the currency loss, use EAD × LGD.
Recovery rate
Recovery rate = 1 − LGD (as a percentage of exposure)
Recovery is the amount recovered divided by the amount owed.
Loss if default occurs
Loss = EAD × LGD
This is a currency amount and is conditional on default. It is not the expected loss.

How to solve Credit Risk Basics: Default Risk and Loss Severity questions

Use this order for any question on default risk and loss severity.

  1. 1Identify what is given: PD, recovery rate or LGD, and the exposure amount.
  2. 2Check whether the question asks for a conditional loss (if default occurs) or an expected loss (probability-weighted).
  3. 3Convert recovery rate to LGD with LGD = 1 − recovery rate, if needed.
  4. 4Compute loss if default = EAD × LGD.
  5. 5For expected loss, multiply by PD: EL = PD × LGD × EAD.
  6. 6Check units: percentages as decimals, and currency in the right amount.
  7. 7Sanity check: EL must be smaller than the loss if default, because PD is below 1.

Quickest way: PD × (1 − RR) shortcut

When to use it: Use when the question gives PD and a recovery rate and asks for expected loss as a percentage or a currency amount.

  1. Write 1 − recovery rate to get LGD.
  2. Multiply by PD as a decimal.
  3. Multiply by exposure if a currency answer is needed.
  4. Match the result to the three options, which are in ascending order, and discard the others.

Common mistakes in Credit Risk Basics: Default Risk and Loss Severity

  • Using the recovery rate in place of LGD in the expected loss formula.

    Both are percentages of exposure and the question may give only the recovery rate.

    Fix: Always convert first: LGD = 1 − recovery rate.

  • Treating loss if default occurs as the expected loss.

    The PD step is skipped.

    Fix: Expected loss includes PD. Loss given default is conditional on default.

  • Confusing default risk with loss severity.

    Both are described as credit risk.

    Fix: Default risk is how likely, loss severity is how much. PD is the first, LGD is the second.

  • Entering PD as 2 instead of 0.02.

    Rushing with percentages.

    Fix: Convert percentages to decimals before multiplying.

  • Assuming a high rating means a low LGD.

    Ratings mostly reflect likelihood of default.

    Fix: LGD depends on seniority and collateral, not just the rating.

Worked examples

Example 1

A bank has an exposure at default of $5,000,000 to a borrower. The probability of default over one year is 2%, and the recovery rate is 40%. What is the expected loss? Options: A) $40,000 B) $60,000 C) $100,000

Show the solution
  1. LGD = 1 − 0.40 = 0.60.
  2. Loss if default = $5,000,000 × 0.60 = $3,000,000.
  3. EL = 0.02 × $3,000,000 = $60,000.

Answer: B) $60,000

Example 2

A senior bond has a PD of 3% and an LGD of 35%. A subordinated bond from the same issuer has a PD of 3% and a recovery rate of 20%. What is the expected loss, as a percentage of exposure, on the subordinated bond? Options: A) 1.05% B) 2.40% C) 3.00%

Show the solution
  1. Subordinated LGD = 1 − 0.20 = 0.80.
  2. EL = 0.03 × 0.80 = 0.024 = 2.40%.
  3. Note that 1.05% is the senior bond (0.03 × 0.35) and 3.00% is the PD alone.

Answer: B) 2.40%

Exam tips

  • Look for the recovery rate in the stem and convert it to LGD before anything else.
  • Wrong options often match PD alone, loss given default alone, or the senior bond answer. Compute before choosing.
  • Read whether the question asks for a conditional loss or an expected loss.
  • With no penalty for wrong answers, never leave a question blank. Eliminate the option that ignores PD, then pick.
  • Remember that recovery usually rises with seniority and collateral.

Practice questions from Credit Risk

Credit Risk Basics: Default Risk and Loss Severity 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 Basics: Default Risk and Loss Severity: frequently asked questions

What is the credit risk expected loss formula?

Expected loss = probability of default × loss given default × exposure at default. If you only need a percentage of exposure, use PD × LGD. LGD equals 1 minus the recovery rate.

What is the difference between default risk and loss severity?

Default risk is the probability that the borrower fails to pay. Loss severity is the share of the exposure you lose if it does fail. Expected loss combines the two.

How do I get loss given default from the recovery rate?

Subtract the recovery rate from 1. A 40% recovery rate means a 60% LGD. Both are measured relative to the amount owed.

Can a high-PD bond have a low LGD?

Yes. If the bond is senior and secured by valuable collateral, recovery can be high even when default is likely. PD and LGD are separate drivers of credit risk.