FRM Part I · FRM Exam Part I · Measuring Credit Risk
A bank has a loan with exposure at default of USD 8 million, a one-year probability of default of 2.5%, and a loss given default of 40%. Assuming these inputs are independent, what is the expected loss?
The expected loss is USD 80,000. Expected loss equals exposure at default times probability of default times loss given default, which is 8 million times 2.5% times 40%. Leaving out the loss given default would wrongly give USD 200,000.
- AUSD 80,000Correct
- BUSD 200,000
- CUSD 320,000
- DUSD 800,000
Explanation
EL = EAD x PD x LGD = 8,000,000 x 0.025 x 0.40 = 80,000. The USD 200,000 figure omits LGD (8m x 2.5%). The USD 320,000 figure omits PD (8m x 40%).
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