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FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management

A bank holds a loan portfolio with exposure at default of USD 50 million, a one-year probability of default of 2%, and loss given default of 40%. What is the expected loss for the year?

Expected loss equals probability of default times loss given default times exposure at default: 2% x 40% x USD 50 million = USD 0.4 million. Ignoring loss given default would overstate the loss at USD 1.0 million because it assumes nothing is recovered.

  1. AUSD 0.4 millionCorrect
  2. BUSD 1.0 million
  3. CUSD 0.8 million
  4. DUSD 20 million

Explanation

Expected loss = PD x LGD x EAD = 0.02 x 0.40 x 50 million = USD 0.4 million. Omitting LGD gives USD 1.0 million (0.02 x 50), which wrongly assumes the whole exposure is lost on default. Using LGD x EAD without PD gives USD 20 million.

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