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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A bank has a term loan to Harbor Metals with a one-year PD of 2.5%. The outstanding drawn balance is USD 8 million, the loan is secured and the expected recovery rate on default is 60% of the exposure. The loan carries no undrawn commitment. What is the one-year expected loss?

Expected loss is USD 80,000. Loss given default is 40% because recovery is 60%, so EL equals 2.5% times 40% times USD 8 million. Using the recovery rate as LGD gives USD 120,000, and ignoring recovery gives USD 200,000, both wrong.

  1. AUSD 80,000Correct
  2. BUSD 120,000
  3. CUSD 200,000
  4. DUSD 300,000

Explanation

LGD = 1 - 60% = 40%. EL = 0.025 x 0.40 x 8,000,000 = 80,000. Check: PD x EAD = 200,000, and 40% of that is 80,000. Option C ignores recovery (LGD of 100%); option B uses a 60% LGD, treating the recovery rate as the loss rate.

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