FRM Part II · FRM Exam Part II · Portfolio Credit Risk
A bank holds a single loan of USD 10 million with a one-year probability of default of 2%, loss given default of 40%, and exposure at default equal to the full balance. What is the expected loss on this loan?
Expected loss is the product of default probability, loss given default and exposure at default. Here that is 2% times 40% times USD 10 million, giving USD 80,000. Leaving out the loss given default would overstate the figure at USD 200,000.
- AUSD 80,000Correct
- BUSD 200,000
- CUSD 400,000
- DUSD 4,000,000
Explanation
Expected loss = PD x LGD x EAD = 0.02 x 0.40 x 10,000,000 = USD 80,000. The USD 200,000 option omits LGD (0.02 x 10m). The USD 400,000 option ignores PD in the wrong way (0.04 x 10m), and USD 4,000,000 is EAD x LGD with no PD.
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