FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment
A bank has a single loan with exposure at default of $10 million, a one-year probability of default of 2%, and loss given default of 40%. Treating EAD and LGD as fixed, what is the expected loss on the loan?
Expected loss equals probability of default times loss given default times exposure at default. With 2%, 40% and $10 million, the result is $80,000. Ignoring the recovery assumption would overstate the loss at $200,000.
- A$80,000Correct
- B$200,000
- C$400,000
- D$800,000
Explanation
EL = PD x LGD x EAD = 0.02 x 0.40 x 10,000,000 = $80,000. Omitting LGD gives $200,000, and omitting PD gives $4 million-based figures; $400,000 would use PD x EAD x 2 incorrectly, and $800,000 is a scaling error.
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