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FRM Exam Part I · Measuring Credit Risk

Credit Risk Mitigation and Recovery Rates: Recovery Rate and LGD

Updated 11 October 2026 · Fact-checked

Recovery rate is the share of exposure you get back after a default. Loss given default (LGD) is the share you lose: LGD = 1 − recovery rate. Collateral, netting and guarantees cut the exposure or raise recovery, and senior claims recover more than junior ones. Expected loss = PD × LGD × EAD.

Understand Credit Risk Mitigation and Recovery Rates

Credit risk is the risk that a counterparty fails to pay. Two questions matter: how likely is default, and how much do you lose if it happens? This topic covers the second question.

When a borrower defaults, you rarely lose everything. The recovery rate is the fraction of the exposure you recover, through liquidation, restructuring or payments from collateral and guarantors. Loss given default (LGD) is the fraction you lose. The two always add to 100%, so a 40% recovery means a 60% LGD. Be careful about the base: both are usually stated as a percentage of exposure at default (EAD), not of the original loan.

Seniority drives recovery. In bankruptcy, claims are paid in order of priority: secured creditors first (from their collateral), then senior unsecured, then subordinated, then equity. Senior secured debt typically recovers most and subordinated debt least. Recovery is also not constant. It tends to be lower when many firms default at once, such as in a recession, because collateral values fall. This negative link between default rates and recovery rates raises portfolio risk.

Credit risk mitigants reduce loss. Collateral is an asset pledged to the lender. It lowers exposure, but its value can fall (haircuts are applied) and may be hit by the same shock that causes default. Netting lets you offset positive and negative contract values with the same counterparty, so only the net amount is at risk. It works only if it is legally enforceable. Guarantees transfer risk to a third party. The loss occurs only if both borrower and guarantor default, so the guarantor's credit quality and its correlation with the borrower matter.

You combine these ideas in expected loss: EL = PD × LGD × EAD. Mitigants lower EAD or LGD, which lowers EL.

Key formulas to remember

LGD and recovery rate
LGD = 1 − RR
Both are measured as a percentage of exposure at default.
Expected loss
EL = PD × LGD × EAD
PD is the probability of default over the horizon. EAD is the exposure at default.
Loss in currency
Loss = EAD × (1 − RR)
Applies once default has occurred.
Netted exposure
Net exposure = max(Σ contract values, 0)
Only valid with legally enforceable netting. Without it, exposure = Σ max(value, 0).
Collateral-adjusted exposure
Exposure after collateral = max(EAD − collateral × (1 − haircut), 0)
The haircut reduces the collateral value you can count on.
Guarantee (substitution) approach
P(loss) ≈ P(borrower default and guarantor default)
For independent parties this is PD(borrower) × PD(guarantor). Positive correlation raises it.
Seniority order
Secured > Senior unsecured > Subordinated > Equity
Higher priority usually means higher recovery and lower LGD.

How to solve Credit Risk Mitigation and Recovery Rates questions

Use this order for any question on mitigation, recovery or LGD.

  1. 1Identify what is asked: recovery rate, LGD, exposure after mitigants, or expected loss.
  2. 2Write down EAD and the claim's seniority or security status.
  3. 3Apply mitigants to exposure first: net the contracts (if netting is enforceable), then subtract collateral after haircut.
  4. 4Compute the unprotected amount and the recovery on it, using the given recovery rate or the order of priority.
  5. 5Convert to LGD: LGD = 1 − RR, or loss ÷ EAD.
  6. 6If PD is given, compute EL = PD × LGD × EAD, keeping PD, LGD and EAD on the same base and horizon.
  7. 7For guarantees, check whether both parties must default, and think about their correlation.
  8. 8Sanity check: LGD must lie between 0% and 100%, and mitigants must never raise loss.

Quickest way: Exposure first, then LGD, then EL

When to use it: Use for numeric multiple-choice questions where time is short.

  1. Write EAD, then subtract netting benefit and haircut-adjusted collateral. Floor at zero.
  2. Take LGD = 1 − RR on what is left, or loss ÷ original EAD if asked for LGD of the whole position.
  3. Multiply PD × LGD × EAD only if PD is given.
  4. For conceptual options, pick the answer where seniority and collateral reduce loss, and where correlation between guarantor and borrower raises it.

Common mistakes in Credit Risk Mitigation and Recovery Rates

  • Treating recovery rate and LGD as the same number.

    Both describe the outcome of default, so they get mixed up.

    Fix: They are complements: LGD = 1 − RR. Check which one the question asks for.

  • Ignoring haircuts on collateral.

    Students use the full market value of the collateral.

    Fix: Multiply collateral by (1 − haircut) before subtracting it from exposure.

  • Netting exposures when netting is not enforceable, or netting across different counterparties.

    Netting looks like simple addition.

    Fix: Net only contracts with the same counterparty under an enforceable agreement. Otherwise sum the positive values only.

  • Allowing negative exposure after collateral.

    Collateral exceeds exposure and the subtraction goes below zero.

    Fix: Floor exposure at zero. Excess collateral does not create a gain.

  • Assuming a guarantee removes all risk.

    The guarantor is seen as risk-free.

    Fix: Loss still occurs if the guarantor also defaults. Higher correlation makes joint default more likely.

  • Assuming recovery rates are constant across the cycle.

    Textbook examples use a fixed figure.

    Fix: Remember that recovery tends to fall when default rates rise, which increases portfolio risk.

Worked examples

Example 1

A bank has three derivative contracts with one counterparty, valued at +₹80 lakh, −₹30 lakh and +₹20 lakh. A legally enforceable netting agreement exists. The counterparty defaults and the recovery rate on the net claim is 40%. What is the bank's loss with netting, and how much does netting save compared with no netting? Use ₹ in lakh.

Show the solution
  1. Net exposure = 80 − 30 + 20 = ₹70 lakh.
  2. Loss with netting = 70 × (1 − 0.40) = ₹42 lakh.
  3. Without netting, exposure = sum of positive values = 80 + 20 = ₹100 lakh.
  4. Loss without netting = 100 × 0.60 = ₹60 lakh.
  5. Saving = 60 − 42 = ₹18 lakh.

Answer: Loss with netting is ₹42 lakh. Netting saves ₹18 lakh compared with ₹60 lakh without it.

Example 2

A USD 10 million loan to a firm is secured by collateral worth USD 6 million, subject to a 10% haircut. The remaining unsecured claim recovers 25%. PD over one year is 2%. Find the loss given default as a percentage of EAD and the expected loss.

Show the solution
  1. Usable collateral = 6 × (1 − 0.10) = USD 5.4 million.
  2. Unsecured exposure = 10 − 5.4 = USD 4.6 million.
  3. Recovery on unsecured part = 4.6 × 0.25 = USD 1.15 million.
  4. Loss = 4.6 − 1.15 = USD 3.45 million.
  5. LGD = 3.45 ÷ 10 = 34.5%.
  6. EL = PD × LGD × EAD = 0.02 × 0.345 × 10 = USD 0.069 million.

Answer: LGD is 34.5% of EAD and expected loss is USD 69,000.

Exam tips

  • Read whether the recovery rate is given on the whole claim or only on the unsecured portion.
  • Always floor exposure at zero after netting and collateral.
  • Know the direction of effects: seniority and collateral reduce LGD, correlation between guarantor and borrower raises joint default risk.
  • Expect conceptual items on the link between default rates and recovery rates in downturns.
  • Use the financial calculator or memory for simple arithmetic, but write each step to avoid slips with percentages.

Practice questions from Measuring Credit Risk

Credit Risk Mitigation and Recovery Rates 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 Mitigation and Recovery Rates: frequently asked questions

What is the difference between recovery rate and LGD?

Recovery rate is the fraction of exposure you get back after default. LGD is the fraction you lose, so LGD = 1 − recovery rate. Both are normally measured against exposure at default.

How does seniority affect recovery rates?

Seniority sets the order of payment in bankruptcy. Secured and senior claims are paid before subordinated claims and equity, so they usually recover more and have a lower LGD. Actual recovery depends on the value of the assets available.

Why can collateral still leave you with a loss?

Collateral can lose value, and haircuts reduce what you can count on. It can also fall in value at the same time the borrower defaults. If collateral is less than exposure, the gap remains at risk.

Does netting always reduce credit exposure?

Netting never increases exposure and usually reduces it, but only if it is legally enforceable and the contracts are with the same counterparty. If it is not enforceable, you must treat each positive contract separately.