The fraction of exposure lost when a borrower defaults, equal to one minus the recovery rate; combined with default probability it gives expected credit loss.
Expected loss is probability-of-default multiplied by LGD multiplied by exposure. That identity is the backbone of bank credit provisioning and of any decision about whether a spread pays you enough.
LGD is driven by collateral, seniority and the industry's asset intangibility. A lender secured on aircraft or property recovers more than one lending against a software firm's goodwill, which is why covenant and collateral analysis is not academic.
Example: exposure $20 million, default probability 4%, LGD 65%. Expected annual credit loss is $20m x 0.04 x 0.65 = $520,000, or 260 basis points. A spread of 200 basis points does not pay for that risk.
Original diagrams for the ideas on this page. Illustrative, not real market data.
The bid-ask spread. Buy orders sit below, sell orders above, and the gap between the best bid (50.01) and best ask (50.04) is the spread you pay to cross. Bar length shows the size resting at each price.
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