FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk
A bank has a USD 5 million loan with a one-year PD of 3%. If default occurs, the bank expects to recover 60% of the exposure. What is the one-year expected loss?
Loss given default is one minus the 60% recovery rate, or 40%. Expected loss is 3% x 40% x USD 5 million = USD 60,000. Using the recovery rate directly as LGD would wrongly give USD 90,000.
- AUSD 90,000
- BUSD 60,000Correct
- CUSD 150,000
- DUSD 300,000
Explanation
LGD = 1 - recovery rate = 40%. EL = 0.03 x 0.40 x 5,000,000 = USD 60,000. USD 90,000 mistakenly uses the 60% recovery rate as LGD.
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