FRM Part I · FRM Exam Part I · Measuring Credit Risk
A bank has a loan exposure of USD 10 million to a borrower with a one-year probability of default of 2% and a loss given default of 45%. Using expected loss = PD x LGD x EAD, what is the expected loss?
Expected loss is PD times LGD times exposure: 2% x 45% x USD 10 million, which equals USD 90,000. The figure of USD 200,000 ignores recovery and treats the whole exposure as lost on default.
- AUSD 90,000Correct
- BUSD 200,000
- CUSD 45,000
- DUSD 110,000
Explanation
EL = 0.02 x 0.45 x 10,000,000 = USD 90,000. Using PD x EAD only gives USD 200,000, which ignores the recovery. USD 45,000 would come from halving the PD by mistake.
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