Skip to content

FRM Part II · FRM Exam Part II · Derivatives

A bank estimates the expected positive exposure (EPE) profile to a counterparty over one year using the following exposure at three equally spaced dates, each representing one-third of the year: EE = USD 6 million, USD 9 million, USD 3 million. The one-year default probability is 3% and recovery is 40%. Using the average EE as an approximation of exposure, and assuming exposure independent of default, what is the approximate expected credit loss?

Average expected exposure is (6+9+3)/3 = USD 6 million. Multiplying by the 3% default probability and the 60% loss given default (one minus 40% recovery) gives an expected credit loss of about USD 0.108 million, assuming independence between exposure and default.

  1. AUSD 0.18 million
  2. BUSD 0.108 millionCorrect
  3. CUSD 0.324 million
  4. DUSD 0.054 million

Explanation

Average EE = (6 + 9 + 3)/3 = 6 million. Loss given default = 60%. Expected loss = 6 × 0.03 × 0.60 = 0.108 million. The 0.18 option omits the recovery adjustment. The 0.324 option uses the peak EE (9) with LGD. The 0.054 option wrongly applies recovery twice.

Did you get it right without looking?

One question tells you little. A timed set on Derivatives shows your real accuracy, how long you take and where you lose marks.

Practise DerivativesFree diagnostic mock

More Derivatives questions