Expected Loss

Expected Loss is a financial metric that estimates the average loss a lender, investor, or company can expect to incur from credit risk exposure over a specified period. It is calculated as the product of three factors: the probability of default (PD), loss given default (LGD), and exposure at default (EAD). Expected Loss is widely used in credit risk management to assess the potential impact of default on a portfolio, helping institutions set appropriate reserves, pricing strategies, and risk mitigation measures. Banks and financial institutions use expected loss calculations to comply with regulatory requirements and to maintain adequate capital buffers against potential credit losses.

Example

A bank with a loan portfolio where the probability of default is 5%, the loss given default is 50%, and the exposure at default is $1 million would have an expected loss of $25,000.