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

A bank has a loan exposure of USD 4,000,000 to a corporate borrower. The one-year probability of default is 2.5%, and the loss given default is 40% of the exposure at default. What is the expected loss on this loan over one year?

Expected loss equals probability of default times loss given default times exposure at default. Here that is 2.5% x 40% x USD 4,000,000, which gives USD 40,000. Omitting the loss severity would overstate the figure at USD 100,000.

  1. AUSD 40,000Correct
  2. BUSD 100,000
  3. CUSD 1,600,000
  4. DUSD 4,000

Explanation

Expected loss = PD x LGD x EAD = 0.025 x 0.40 x 4,000,000 = USD 40,000. USD 100,000 ignores LGD (PD x EAD). USD 1,600,000 uses LGD x EAD without PD.

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