Answer: expected exposure.

## Explanation **Loss Given Default (LGD)** is calculated as: \[ \text{LGD} = 1 - \text{Recovery Rate} \] Where: - **Recovery Rate** = The percentage of the bond's value that investors recover after default - **Expected Exposure** = The amount at risk at the time of default **Analysis of Options:** **A. Recovery Rate** - **INCORRECT** - If recovery rate increases, LGD would **decrease** (since LGD = 1 - Recovery Rate) - Higher recovery means investors get more money back, so loss is lower **B. Expected Exposure** - **CORRECT** - Expected exposure represents the amount at risk when default occurs - If expected exposure increases (due to higher bond prices, larger positions, or different timing of default), the **absolute loss** increases - This directly increases the estimated LGD **C. Probability of Default** - **INCORRECT** - Probability of default affects the **likelihood** of loss occurring, but not the **amount** of loss given that default happens - LGD measures the severity of loss **conditional on default**, not the probability of default **Key Distinction:** - **Probability of Default** = Chance that default will occur - **Loss Given Default** = Amount lost if default occurs - **Expected Loss** = Probability of Default × Loss Given Default Therefore, an increase in **expected exposure** (Option B) is the most likely cause for increased LGD estimates.

Author: LeetQuiz Editorial Team