Probability of Default/Loss Given Default analysis is a method used by generally larger institutions to calculate expected loss. A probability of default (PD) is already assigned to a specific risk measure, per guidance, and represents the percentage expectation to default, measured most frequently by assessing past dues. Loss given default (LGD) measures the expected loss, net of any recoveries, expressed as a percentage and will be unique to the industry or segment. PD is typically calculated by running a migration analysis of similarly rated loans, over a prescribed time frame, and measuring the percentage of loans that default. That PD is then assigned to the risk level; each risk level will only have one PD percentage. In this problem we find out the probability that a firm is in default after some years, give some probability of default in a year. This is a favorite problem in FRM and CFA examination.
