Convert severity to an amount
For exposure of 100,000 and LGD of 45%, the default-event loss is 45,000. Multiplying LGD by exposure gives a conditional amount, not a probability-weighted expected amount. Default probability must be included for the latter in the simple two-outcome model.
Use recovery consistently
If recovery and loss are measured against the same exposure amount and at the same valuation date, a 55% recovery corresponds to 45% loss. Timing, collection costs and the exposure definition can complicate that relationship in a more detailed model. State the simplified assumptions before using one minus recovery.
| Recovery fraction | LGD |
|---|---|
| 0% | 100% |
| 55% | 45% |
| 100% | 0% |
Avoid confusing two percentages
A 2% PD and a 45% LGD are not competing estimates of the same quantity. One measures likelihood; the other measures conditional severity. Their product is 0.9%, the expected-loss fraction in the example with zero non-default loss.