Sep 04

Expected loan return – 5.5 min screencast

by David Harper, CFA, FRM, CIPM

The expected return on a loan adjusts for default risk. Using Saunder’s notation (FRM candidates), if p = probability of repayment, then 1-p = probability of non-repayment. The expected non-repayment, E[loan amount*(1-p)], is an expected loss (EL) that generally is covered by loan loss provisions (a contra-asset account). A “cost of doing business”.

And (see end of screencast), (k) and (p) are not independent: higher k implies riskier loans and higher expected default. As (k) and (p) are strongly negatively correlated, beyond a certain point, higher contractually promised returns correspond to lower expected returns.

Screencast: