{"id":3487,"date":"2019-09-06T12:00:00","date_gmt":"2019-09-06T12:00:00","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=3487"},"modified":"2026-03-31T14:02:23","modified_gmt":"2026-03-31T14:02:23","slug":"credit-risk-default-probability-loss-severity","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/fixed-income\/credit-risk-default-probability-loss-severity\/","title":{"rendered":"Credit Risk &#8211; Default Probability and Loss Severity"},"content":{"rendered":"\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"VideoObject\",\n  \"name\": \"Fundamentals of Credit Analysis (2025 Level I CFA\u00ae Exam \u2013 Fixed Income \u2013 Module 6)\",\n  \"description\": \"This video lesson discusses fundamentals of credit analysis, covering credit risks, default probability, seniority rankings, credit ratings, and financial ratios. It also explores the four Cs of credit analysis and evaluates factors influencing yield spreads and credit quality for various issuers, including high-yield and government debt.\",\n  \"uploadDate\": \"2022-06-22T00:00:00+00:00\",\n  \"thumbnailUrl\": \"https:\/\/img.youtube.com\/vi\/zSl9z7qQB00\/maxresdefault.jpg\",\n  \"contentUrl\": \"https:\/\/www.youtube.com\/watch?v=zSl9z7qQB00\",\n  \"embedUrl\": \"https:\/\/www.youtube.com\/embed\/zSl9z7qQB00\",\n  \"duration\": \"PT41M06S\"\n}\n<\/script>\n\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"An analyst estimates that a bond issue has a 20% probability of default over the next year and the recovery rate in the event of default is 80%. If a firm holds $1 million worth of this bond issue, then the expected loss is closest to:\",\n    \"text\": \"An analyst estimates that a bond issue has a 20% probability of default over the next year and the recovery rate in the event of default is 80%. If a firm holds $1 million worth of this bond issue, then the expected loss is closest to:\",\n    \"answerCount\": 3,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"$40,000.\"\n    },\n    \"suggestedAnswer\": [\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"$160,000.\"\n      },\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"$640,000.\"\n      }\n    ]\n  }\n}\n<\/script>\n\n\n\n<iframe loading=\"lazy\"\n  width=\"611\"\n  height=\"344\"\n  src=\"https:\/\/www.youtube.com\/embed\/zSl9z7qQB00\"\n  title=\"YouTube video player\"\n  frameborder=\"0\"\n  allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share\"\n  referrerpolicy=\"strict-origin-when-cross-origin\"\n  allowfullscreen>\n<\/iframe>\n\n\n<p>Credit risk is the risk of loss resulting from a borrower\u2019s failure to make full and timely payments of interest and\/or principal. Credit risk is made up of 2 components:<\/p>\n<ul>\n<li><strong>default risk or default probability<\/strong>: probability that a borrower will violate the terms of the debt security;<\/li>\n<li><strong>loss severity or loss given default<\/strong>: the portion of the value of a bond, including unpaid interest, an investor loses in the event of default.<\/li>\n<\/ul>\n<div style=\"margin: 20px 0;\"><a style=\"display: block; width: 100%; text-align: center; padding: 10px; border: 2px solid #2f5bea; border-radius: 40px; font-size: 16px; color: #2f5bea; text-decoration: none;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener\"> Practice credit risk and expected loss questions with our free trial. <\/a><\/div>\n<h2><strong>Expected Loss<\/strong><\/h2>\n<p>Credit risk is reflected in the distribution of potential losses that may arise if an investor is not paid in full and on time. It is common practice to summarize the risk with a single default probability and loss severity so as to simply focus on the expected loss:<\/p>\n<p>$$ \\text{Expected loss = Default probability} \u00d7 \\text{Loss given default} $$<\/p>\n<h3><strong>Loss Severity<\/strong><\/h3>\n<p>Loss severity could be expressed either as a monetary amount (e.g., $250,000) or as a percentage of the principal amount (e.g., 35%). In addition, loss severity, or loss given default, is also expressed as (1- Recovery rate), where the recovery rate is described as the percentage of the principal amount recovered in the event of default.<\/p>\n<blockquote>\n<h3><strong>Question<\/strong><\/h3>\n<p>An analyst estimates that a bond issue has a 20% probability of default over the next year and the recovery rate in the event of default is 80%. If a firm holds $1 million worth of this bond issue, then the expected loss is <em>closest<\/em> to:<\/p>\n<ol style=\"list-style-type: upper-alpha;\">\n<li data-tadv-p=\"keep\">$40,000<\/li>\n<li data-tadv-p=\"keep\">$160,000<\/li>\n<li data-tadv-p=\"keep\">$640,000<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p>The correct answer is <strong>A<\/strong>.<\/p>\n<p>Expected loss = Default probability \u00d7 Loss given default<\/p>\n<p>Loss given default = (1 &#8211; Recovery rate) = 1 &#8211; 80% = 20%<\/p>\n<p>Expected loss = 20%\u00a0\u00d7 20% = 4%<\/p>\n<p>In dollar amount: $1 million \u00d7 4% = $40,000<\/p>\n<\/blockquote>\n<div style=\"text-align: center; margin: 40px 0;\"><a style=\"display: inline-block; padding: 10px 26px; background: #3f78d7; color: #fff; border-radius: 40px; font-size: 16px; text-decoration: none;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener\"> Start Free Trial \u2192 <\/a>\n<p style=\"margin-top: 10px; max-width: 600px; margin-left: auto; margin-right: auto; font-size: 14px;\">Solve CFA-style fixed income questions on default probability, loss severity, and expected loss.<\/p>\n<\/div>","protected":false},"excerpt":{"rendered":"<p>Credit risk is the risk of loss resulting from a borrower\u2019s failure to make full and timely payments of interest and\/or principal. Credit risk is made up of 2 components: default risk or default probability: probability that a borrower will&#8230;<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[9],"tags":[],"class_list":["post-3487","post","type-post","status-publish","format-standard","hentry","category-fixed-income","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Credit Risk, Default Probability &amp; Loss Severity | CFA<\/title>\n<meta name=\"description\" content=\"Credit risk measures the likelihood of default and loss severity. 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