With this LGD calculator, we are here to help you calculate a company's loss given default. Loss given default (LGD) is an important concept to understand, especially when analyzing a company's credit quality. In particular, it tells you how much money you will lose if the company you invest defaults on its debt.
We wrote this article to help you understand what is LGD and how to calculate LGD. To facilitate you in understanding the concept, we will also demonstrate a loss given default example. But before we dive into the calculation, we will start with explaining the LGD's meaning.
What is loss given default?
LGD, which stands for loss given default, represents the amount of money you risk losing if the company you invest in goes bankrupt. It is a valuable metric in assessing the credit risk of a company before investing in it.
Unlike other liquidity ratios, such as the current ratio and credit spread, which tell you the company's financial position and how likely it will default, the LGD calculates how much you will lose if a credit event does actually happen. To understand more on this metrics, check out our current ratio calculator and credit spread calculator. This metric can help you to understand the worst-case scenarios of your portfolio.
Now that we have understood what LGD is, we can look at how to use this metric in a loss given the default example.
How to calculate the loss given default?
We will examine an investment in Company Alpha as our loss given default example to help you understand how to calculate the loss given default.
Company Alpha reports the following information:
- Company name: Company Alpha
- Recovery rate: 80%
- Loss severity: 20%
- Expected exposure in Company Alpha: $1,000,000
Determine the recovery rate or loss severity.
The first step is to understand the relationship between
loss severity. Their relationships are depicted as the following formula:
recovery rate = 1 - severity
`loss severity = 1 - recovery rate` To proceed with the calculation, we need to have at least one of them. In this example, we assume the `recovery rate` of `80%`, hence `loss severity` of `20%`.
Determine the expected exposure.
The next step is to determine the
expected exposure. The
expected exposurecan be interpreted as the amount of investment you put into your investment. For our example, the
expected exposurein Company Alpha is
Calculate the loss given default (LGD).
The final step is to calculate the LGD. We can do this by using the following formula:
LGD = expected exposure * loss severity
LGD = expected exposure * (1 - recovery rate)
In the example, the
LGDof the Company Alpha is:
$1,000,000 * 20% = $200,000.
Why is calculating LGD useful?
After we understand what is loss given default, we can now discuss why it is useful:
Advantage: The most prominent use for calculating LGD is allowing you to understand how much money you can probably lose in the investment, i.e., it tells you the worst-case scenario. Thus, it can help to assess if the LGD is a loss that you can possibly stomach.
Disadvantage: However, the LGD does not tell you the probability of the company going default. One investment may have a small LGD but a high probability of default and vice versa. This scenario can make LGD an interior metric to assess investment risks.
Does high LGD means high investment risks?
The short answer is not necessarily. A high LGD only tells you that you will lose a lot of the company goes default, but it does not tell you how likely that will happen.
What is the difference between LGD and liquidity ratios?
Liquidity ratios tell you how likely a company is going to default, whereas LGD focuses on quantifying the negative impact following the default.
Can I use LGD to assess credit risk?
Yes, but it is dangerous to use it alone. LGD is often used with other liquidity ratios to work out both the probability of default and its impact.
Can LGD be zero?
Theoretically speaking, yes. If the company has enough assets that can be liquidated and pay off its debt, its LGD can technically be zero. This, however, is very unusual.