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CMA Final · Risk Management in Banking and Insurance · Credit Risk Management

A bank has a term loan with EAD of Rs 80 lakh, one-year PD of 3% and LGD of 40%. What is the expected loss on this loan?

Expected loss is 3% × 40% × Rs 80 lakh, which equals Rs 0.96 lakh. The loan's default probability and the share lost on default are both applied to the exposure. Ignoring LGD would wrongly give Rs 2.40 lakh.

  1. ARs 0.96 lakhCorrect
  2. BRs 2.40 lakh
  3. CRs 0.32 lakh
  4. DRs 9.60 lakh

Explanation

EL = 0.03 × 0.40 × 80 lakh = 0.012 × 80 = Rs 0.96 lakh. Rs 2.40 lakh ignores LGD (PD × EAD). Rs 0.32 lakh uses LGD × EAD × 1% mis-scaling, i.e. a misplaced decimal on PD. Rs 9.60 lakh is a decimal-place error.

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