Chartered Financial Analyst (CFA) Practice Exam Level 2 - 2025 Free CFA Level 2 Practice Questions and Study Guide

The primary factor in assessing credit risk through Credit Ratings is the combination of Probability of Default (PD) and Loss Given Default (LGD). Understanding credit ratings involves evaluating how likely a borrower is to default on their obligations (PD) and the expected loss if a default occurs (LGD).

Probability of Default refers to the likelihood that a borrower will not be able to make the required payments on their debt obligations. Loss Given Default is the amount of loss that a creditor can expect to incur if the borrower defaults, expressed as a percentage of the total exposure. By multiplying these two factors together, analysts can assess the expected loss from the potential default, which is a critical measure for assigning credit ratings.

This method provides a quantitative basis for evaluating credit risk and helps investors and creditors make informed decisions regarding the likelihood of receiving their expected returns. It moves beyond subjective measures and focuses on empirical data regarding borrower performance and overall risk management. Hence, these two factors are pivotal in deriving a credit rating that reflects the borrower’s financial health and repayment capability.