Skip to content

FRM Part I · FRM Exam Part I · Measuring Credit Risk

A bank has an unsecured loan exposure of USD 10 million to a counterparty. The one-year probability of default is 2% and the recovery rate is 40%. Using the expected loss = PD x LGD x EAD framework, what is the expected loss?

Expected loss is USD 120,000. Loss given default equals one minus the 40% recovery rate, or 60%. Multiplying the 2% default probability by 60% and by the USD 10 million exposure gives 120,000. Using recovery instead of loss severity understates the loss.

  1. AUSD 80,000
  2. BUSD 120,000Correct
  3. CUSD 200,000
  4. DUSD 480,000

Explanation

LGD = 1 - 40% = 60%. EL = 0.02 x 0.60 x 10,000,000 = USD 120,000. Using the recovery rate directly as LGD gives USD 80,000, which is wrong. Ignoring recovery gives USD 200,000.

Did you get it right without looking?

One question tells you little. A timed set on Measuring Credit Risk shows your real accuracy, how long you take and where you lose marks.

Practise Measuring Credit RiskFree diagnostic mock

More Measuring Credit Risk questions