This is an indication of how much an investor could get back if a default occurred.
recovery rate and loss given default
when an agent defaults it is not neceassrily the case that lenders lose all of their money.
A defaulting agent will be wound down; assets will be sold and creditors paid.
A lender needs to consider what proportion of cash would be recoverable in the event of a default.
This recovery rate (RR) represents the ratio of cash repaid to that at risk.
The same concept as RR is often expressed through Loss Given Default (LGD) = (1 - RR)
These usually take on specific dispersions
There is a significant difference in recovery rates according to the type of industry as well as the geographical location.
The recovery rate on bank debt has historically been much higher than that on senior secured bonds.
Example - bond debt - 74%
senior secured bonds - 45%
senior unsecured bonds - 36%
senior subordinates bonds - 21%
subordinated bonds - 15%
junior subordinated bonds - 3%
3) expected loss
A simple equation for expected loss is
expected loss = exposure at default * probability of default * (1 - RR)
expected loss = EAD * probability at default * LGD
Company A owns $50m worth of five year bonds issued by company B
The recovery rate is 30%
Company A calculates a 0.05% default over the next 5 years
What is the expected loss if held to maturity ?
expected loss = 50m * 0.0005 * (1-0.3)
expected loss = 17,500
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