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.