I don't understand expected loss
I don't understand the utility or the reason of expected loss. In the example the bank would lose 16000 dollars and in any other circunstance it would lose LGD*EAD. What is the utility of the amount 4500?
2 answers ( 0 marked as helpful)
If the borrower defaults on the loan, then the bank would hypothetically lose 360k (outstanding balance of the home)
But because they know they can resell it for 342k on the market, their new Exposure at Default (max loss) would be 18k
Once we do the calculations to get the Expected Loss (25% * 5% * 360,000), we figure out that out of the $18,000 max loss we’d receive, only $4,500 is unrecoverable.
Based on my understanding, the probability of default is only 25%. Therefore, the amount we loss is 25% of 18,000 that is 4,500