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Explain expected exposure, probability of default, loss given default and the adjustment to value for credit (CVA)

CFA® Level II · Fixed Income · Credit Analysis Models · L2.FI.4.a

The idea

Credit risk splits into four pieces. Expected exposure is the amount at stake if default occurred at a given date, before any recovery, usually the value of the remaining payments at that date. Loss given default is exposure × (1 − recovery rate). The probability of default for a period is the hazard rate multiplied by the probability of surviving to the start of that period, so it falls over time even with a constant hazard. Expected loss for a date is loss given default × probability of default. The credit valuation adjustment is the sum of each expected loss discounted at the risk-free rate, and a bond's fair value is its default-free value minus the CVA.

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