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FRM Part I · FRM Exam Part I · Measuring Credit Risk

A bank has a loan exposure at default of USD 8,000,000 to a borrower with a one-year probability of default of 2.5% and a loss given default of 40%. What is the expected loss on this loan?

Expected loss equals exposure at default times probability of default times loss given default. Here that is 8,000,000 x 2.5% x 40%, which gives USD 80,000. Omitting the loss given default would overstate the loss at USD 200,000.

  1. AUSD 80,000Correct
  2. BUSD 200,000
  3. CUSD 320,000
  4. DUSD 800,000

Explanation

Expected loss = EAD x PD x LGD = 8,000,000 x 0.025 x 0.40 = 80,000. USD 200,000 ignores LGD (8,000,000 x 0.025). USD 320,000 is EAD x LGD with no PD. USD 800,000 is EAD x 10% and has no basis.

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