Expected loss
The chance of default multiplied by the share not recovered. Both are averages, and they worsen together in a recession, so it understates the tail.
Where you will meet it
Expected loss appears in 6 learning outcomes on the CFA syllabus. A few of them:
- Set out the elements that make up credit risk
“Expected loss is the product of the probability of default and the loss given default, which is one minus the recovery rate, applied to the amount exposed.”
- Explain expected exposure, probability of default, loss given default and the adjustment to value for credit (CVA)
“Expected loss for a date is loss given default × probability of default.”
- Weigh risk and return across private credit strategies, and set them against other private market assets, in a strategic allocation
“Deduct expected losses (probability of default × loss given default).”
- Work out expected loss using default probability and loss given default
“Expected loss is the probability of default multiplied by the loss given default, where loss given default is one minus the recovery rate applied to the exposure.”
Practise it
Practise expected loss until it is automatic: questions that explain every wrong option.
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