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CMA Final · Risk Management in Banking and Insurance · Credit Risk Management

A bank has a loan exposure of Rs 50 crore to a borrower. The estimated probability of default (PD) is 2%, loss given default (LGD) is 40%, and exposure at default (EAD) equals the full Rs 50 crore. What is the expected loss on this exposure?

Expected loss equals probability of default times loss given default times exposure at default. Here that is 2% x 40% x Rs 50 crore, giving Rs 0.40 crore. Omitting LGD gives Rs 1 crore, and omitting PD gives Rs 20 crore, both of which are wrong.

  1. ARs 0.40 croreCorrect
  2. BRs 1.00 crore
  3. CRs 0.80 crore
  4. DRs 20.00 crore

Explanation

Expected loss = PD x LGD x EAD = 0.02 x 0.40 x Rs 50 crore = Rs 0.40 crore. Rs 1.00 crore ignores LGD (PD x EAD). Rs 0.80 crore ignores the PD multiplication error by using 0.02 x 0.80 style mistakes, i.e. treating recovery of 60% as loss of 80%. Rs 20 crore is LGD x EAD without PD.

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