FRM Exam Part II · Credit Risk Management

Credit Risk Fundamentals and Credit Analysis for FRM Part II

Updated 11 October 2026 · Fact-checked

Credit risk is the chance of loss because a borrower or counterparty fails to pay what it owes. Expected loss is EL = PD × LGD × EAD, the average loss you provision for. Unexpected loss is the volatility of losses around that average, and capital covers it. Solve questions by identifying each input first.

Understand Credit Risk Fundamentals and Credit Analysis

Credit risk is the risk of loss when a counterparty does not meet its obligations in full and on time. It shows up in loans, bonds, derivatives, trade finance and settlement. Three related forms matter. Default risk is the risk that the borrower fails to pay. Credit spread risk is the risk that the market price of a credit falls because spreads widen, even without default. Downgrade risk is the risk that the borrower's rating falls, which usually widens spreads and raises capital needs.

Every credit loss is built from three parts. Probability of default (PD) is the chance the borrower defaults over a stated horizon, usually one year. Exposure at default (EAD) is the amount owed when default happens. Loss given default (LGD) is the share of EAD you lose after recoveries and costs. LGD = 1 − recovery rate. Multiply the three and you get expected loss.

Expected loss (EL) is the average loss you expect. It is a cost of doing business. Banks price it into loan rates and cover it with provisions. Unexpected loss (UL) is the variability of actual loss around EL, often measured as the standard deviation of the loss distribution. Losses above EL are not predictable, so capital is held against them. Economic capital is often defined as the loss at a high confidence level minus EL.

Credit analysis asks whether the borrower can and will repay. Analysts look at the business and industry, management quality, cash flow and coverage, leverage, liquidity, and the structure of the debt. Capital structure matters because claims rank in order of seniority. Senior secured lenders are repaid first, then senior unsecured, then subordinated debt, then equity. Higher seniority and better collateral mean a lower LGD, even if PD is the same.

The exam tests whether you can separate these ideas. PD is about the borrower. LGD is about the facility and its security. EAD is about how much is drawn at default. Keep them apart and most questions become simple arithmetic plus interpretation.

Key formulas to remember

Expected loss: EL = PD × LGD × EAD; Use the same horizon for PD, usually one year. PD and LGD as decimals.
Loss given default: LGD = 1 − Recovery rate; Recovery rate is a share of EAD. Check whether the question gives recovery or loss.
Expected loss rate: EL rate = EL ÷ EAD = PD × LGD; Useful when exposure is not given.
Exposure at default for a credit line: EAD = Drawn + CCF × Undrawn; CCF is the credit conversion factor, the share of the undrawn limit expected to be drawn by default.
Portfolio expected loss: EL(portfolio) = Σ EL(i); Expected losses add up exactly. Unexpected losses do not, because of correlation.
Unexpected loss of one exposure (fixed LGD and EAD): UL = EAD × LGD × √(PD × (1 − PD)); This is the standard deviation of loss when default is a Bernoulli event and LGD is a known constant.
Economic capital: Economic capital = Credit VaR at confidence level − EL; Capital covers the gap between a tail loss and the average loss.
Recovery by seniority: Absolute priority: senior claims are paid in full before junior claims receive anything; In practice deviations from strict priority occur, but this is the exam default.

How to solve Credit Risk Fundamentals and Credit Analysis questions

Use this sequence for any question on credit risk components, expected loss or credit analysis.

1Identify the horizon and the exposure type: loan, bond, credit line or derivative.
2Extract PD, LGD or recovery rate, and EAD. Convert percentages to decimals.
3If the exposure has an undrawn limit, compute EAD = drawn + CCF × undrawn before anything else.
4Convert recovery to LGD if needed: LGD = 1 − recovery.
5Compute EL = PD × LGD × EAD. For several exposures, add the individual ELs.
6If the question asks about unexpected loss, use the standard deviation formula or the loss distribution, and remember UL is not additive across exposures.
7Interpret: EL relates to pricing and provisions, UL and tail loss relate to capital.
8Check the answer against the options for unit errors, such as percent versus decimal.

Quickest way: Three-input shortcut

When to use it: Use it for numeric expected loss questions when time is short.

Circle PD, LGD (or recovery) and EAD in the stem.
Fix EAD first if there is an undrawn amount.
Multiply PD × LGD to get the loss rate, then multiply by EAD.
Scan the options. If two answers differ by a factor of 10 or 100, recheck your decimals.
For conceptual questions, ask: is it about the borrower (PD), the facility (LGD), or the amount (EAD)?

Common mistakes in Credit Risk Fundamentals and Credit Analysis

Using the recovery rate as LGD.
Both are given as percentages and the stem may only quote recovery.
Fix: Always compute LGD = 1 − recovery before multiplying.
Ignoring the undrawn portion of a credit line.
Students take the drawn balance as EAD.
Fix: Apply EAD = drawn + CCF × undrawn whenever a limit and CCF are given.
Adding unexpected losses across exposures to get portfolio UL.
Expected losses add, so students assume risk adds too.
Fix: Only EL is additive. Portfolio UL depends on default correlation and is lower than the sum when correlation is below one.
Treating credit spread risk as the same as default risk.
Both relate to credit quality.
Fix: Default risk is the loss if the borrower fails. Spread risk is a mark-to-market loss from wider spreads, which can happen with no default.
Thinking capital is held against expected loss.
Both are called loss measures.
Fix: EL is covered by pricing and provisions. Capital absorbs unexpected loss in the tail.
Assuming junior debt has the same LGD as senior debt of the same issuer.
PD is the same for the borrower, so students assume LGD is too.
Fix: LGD depends on seniority and collateral. Subordinated claims usually have higher LGD.

Worked examples

Example 1

A bank has a ₹20,00,00,000 term loan to a corporate borrower with a one-year PD of 2%. Expected recovery if default occurs is 60% of the exposure. Compute the one-year expected loss.

Show the solution

EAD = ₹20,00,00,000, since the loan is fully drawn.
LGD = 1 − 0.60 = 0.40.
EL rate = PD × LGD = 0.02 × 0.40 = 0.008, or 0.8%.
EL = 0.008 × ₹20,00,00,000 = ₹16,00,000.

Answer: Expected loss is ₹16,00,000.

Example 2

A bank grants a USD 10 million revolving credit line to a firm. USD 6 million is drawn. The credit conversion factor on the undrawn amount is 50%. One-year PD is 3% and LGD is 45%. Compute EAD, expected loss, and the unexpected loss (standard deviation of loss) assuming LGD and EAD are fixed.

Show the solution

Undrawn = 10 − 6 = USD 4 million.
EAD = 6 + 0.50 × 4 = USD 8 million.
EL = 0.03 × 0.45 × 8 = USD 0.108 million, which is USD 108,000.
UL = EAD × LGD × √(PD × (1 − PD)) = 8 × 0.45 × √(0.03 × 0.97).
0.03 × 0.97 = 0.0291. √0.0291 = 0.17059.
UL = 3.6 × 0.17059 = USD 0.6141 million.

Answer: EAD is USD 8 million, EL is USD 108,000, and UL is about USD 614,000. UL is far larger than EL, which is why capital is held against it.

Exam tips

Read the horizon. If PD is given for several years, match it to the loss period asked for.
Watch for questions that give recovery rate while asking for loss, and the reverse.
Conceptual questions often test the split: EL for pricing and provisions, UL for capital.
For default versus spread risk questions, look for whether a default actually occurred.
When ranking recovery across debt classes, apply seniority and collateral first.

Practice questions from Credit Risk Management

Credit Risk Fundamentals and Credit Analysis in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Risk Fundamentals and Credit Analysis: frequently asked questions

What is the difference between expected loss and unexpected loss?

Expected loss is the average credit loss, equal to PD × LGD × EAD. Unexpected loss is the variability of actual losses around that average. EL is covered by pricing and provisions, while UL is covered by capital.

What is the difference between default risk and credit spread risk?

Default risk is the loss that arises if the borrower fails to pay. Credit spread risk is the loss in market value when spreads widen, even if no default occurs. A bond holder can suffer spread losses without any default.

How do you calculate expected loss from PD, LGD and EAD?

Multiply the three inputs: EL = PD × LGD × EAD. Convert recovery to LGD first with LGD = 1 − recovery. If there is an undrawn limit, work out EAD before multiplying.

Are expected losses additive across a portfolio?

Yes. Portfolio expected loss is the sum of the individual expected losses. Unexpected loss is not additive because it depends on default correlation.

Why does capital structure matter in credit analysis?

Claims are repaid by seniority. Senior and secured lenders usually recover more than subordinated lenders. So two instruments of the same borrower can have the same PD but different LGD.