FRM Part I · FRM Exam Part I · Measuring Credit Risk
A bank has a loan exposure of USD 10 million to a counterparty with a probability of default (PD) of 2% over one year. The loss given default (LGD) is 60%, and exposure at default is the full USD 10 million. What is the expected loss?
Expected loss equals PD times LGD times exposure at default: 2% x 60% x USD 10 million gives USD 120,000. Using only PD and exposure omits the loss severity, and using the recovery rate instead of LGD understates the loss.
- AUSD 120,000Correct
- BUSD 200,000
- CUSD 600,000
- DUSD 80,000
Explanation
Expected loss = PD x LGD x EAD = 0.02 x 0.60 x 10,000,000 = USD 120,000. USD 200,000 ignores LGD (PD x EAD). USD 600,000 ignores PD. USD 80,000 uses the recovery rate of 40% instead of the LGD.
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