What does the term 'loss given default' refer to?

The term 'loss given default' (LGD) specifically refers to the expected loss that a lender incurs when a borrower defaults on a loan or bond. This concept is crucial in credit risk modeling as it helps financial institutions and investors assess the potential losses they face if a borrower fails to meet their obligations.

LGD is typically expressed as a percentage of the total exposure at the time of default. It takes into account the amount that can be recovered post-default, which highlights the importance of knowing both the default probabilities and the recovery rates when estimating potential losses. In practice, a lower LGD indicates a better recovery scenario, while a higher LGD suggests greater risk.

In contrast, other options reflect different aspects of credit risk assessment: the likelihood of default itself, the recovery rate, or characteristics unrelated to the measurement of loss in the event of default. Therefore, understanding LGD is critical for anyone engaged in portfolio management, risk assessment, or credit analysis as it directly impacts the calculation of expected losses and required capital reserves for potential defaults.