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CMA Final · Risk Management in Banking and Insurance · Sovereign Risk and Insolvency Risk

A bank has an unsecured exposure of Rs 50 crore to a foreign sovereign. The estimated probability of default is 4%, and the loss given default is 60%. Using expected loss = PD x LGD x EAD, what is the expected loss, and by how much would it fall if the LGD were improved to 40% through a guarantee, other things unchanged?

Expected loss is Rs 1.2 crore, being 4% x 60% x Rs 50 crore. With LGD cut to 40% it becomes Rs 0.8 crore, so the guarantee reduces expected loss by Rs 0.4 crore.

  1. ARs 1.2 crore; fall of Rs 0.4 croreCorrect
  2. BRs 2.0 crore; fall of Rs 0.4 crore
  3. CRs 1.2 crore; fall of Rs 0.8 crore
  4. DRs 0.8 crore; fall of Rs 0.4 crore

Explanation

Expected loss = 4% x 60% x 50 = Rs 1.2 crore. With LGD 40%, expected loss = 4% x 40% x 50 = Rs 0.8 crore. The fall is 1.2 - 0.8 = Rs 0.4 crore. Rs 2.0 crore results from ignoring LGD (4% x 50), and Rs 0.8 crore is the revised loss, not the original.

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