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FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management

A bank has a loan of $10 million to a borrower with a one-year probability of default of 2%, an expected loss given default of 40%, and exposure at default equal to the full loan amount. What is the expected loss on this loan?

The expected loss is $80,000. It is computed by multiplying the default probability of 2%, the loss given default of 40% and the exposure of $10 million. Using only PD and exposure would overstate the loss at $200,000 by assuming nothing is recovered.

  1. A$80,000Correct
  2. B$200,000
  3. C$400,000
  4. D$4,000,000

Explanation

Expected loss = PD x LGD x EAD = 0.02 x 0.40 x $10,000,000 = $80,000. The $200,000 option ignores LGD (0.02 x 10m), implicitly assuming a 100% loss on default.

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