Expected loss
Expected loss is the sum of the values of all possible losses, each multiplied by the probability of that loss occurring.
In bank lending (homes, autos, credit cards, commercial lending, etc.) the expected loss on a loan varies over time for a number of reasons. Most loans are repaid over time and therefore have a declining outstanding amount to be repaid. Additionally, loans are typically backed up by pledged collateral whose value changes differently over time vs. the outstanding loan value.
Three factors are relevant in analyzing expected loss:
- Probability of default (PD)
- Exposure at default (EAD)
- Loss given default (LGD)
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