Sep 23

Expected loss (EL) if default and recovery are correlated – 8 min screencast

by David Harper, CFA, FRM, CIPM

FRM |

As Peggy astutely noticed, the expected loss (EL) calculations in the FRM typically assume no correlation (i.e., they assume independence) between probability of default (PD) and loss given default (LGD). In fact, the Basel II internal ratings-based (IRB) approach to a capital charge assumes independence between PD & LGD.

This may be unrealistic, as higher PD (EDF) may correlate with lower recovery (higher LGD). How can we compute expected loss (EL) if there is correlation between EDF/PD and LGD/recovery?

It is a great exercise for an FRM candidate because we can apply the covariance properties studied in Gujarati:

el_correlate

Here is the screencast:

Comments

  1. sridhar 26 Sep 2008

    Great screencast—very nice explanation of variation around a theme. Congrats to Peggy who provoked this!

  2. Atin 12 Nov 2008

    this was helpful..! cemented couple of ideas
    thanks

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