FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk
A bank has a term loan with a one-year probability of default of 2%, a loss given default of 45%, and an exposure at default of USD 10 million. Assuming independence among the three components, what is the one-year expected loss?
Expected loss is the product of PD, LGD and EAD: 2% x 45% x USD 10 million equals USD 90,000. Ignoring the loss severity would give USD 200,000, which overstates the loss because recovery is not considered.
- AUSD 90,000Correct
- BUSD 200,000
- CUSD 450,000
- DUSD 4.5 million
Explanation
Expected loss = PD x LGD x EAD = 0.02 x 0.45 x 10,000,000 = USD 90,000. USD 200,000 ignores LGD (PD x EAD). USD 450,000 uses 4.5% instead of 2% x 45%, and USD 4.5 million is LGD x EAD without PD.
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