FRM Part II · FRM Exam Part II · Portfolio Credit Risk
A bank holds a single loan with exposure at default of USD 10 million, a one-year probability of default of 2%, and loss given default of 40%. Assuming EAD, PD and LGD are all fixed and known, what is the expected loss on the loan?
Expected loss equals exposure times default probability times loss given default: 10 million times 2% times 40% gives USD 80,000. Ignoring the loss given default would overstate the figure at USD 200,000.
- AUSD 80,000Correct
- BUSD 200,000
- CUSD 400,000
- DUSD 800,000
Explanation
Expected loss = EAD x PD x LGD = 10,000,000 x 0.02 x 0.40 = USD 80,000. USD 200,000 omits LGD (EAD x PD). USD 400,000 omits PD (EAD x LGD). USD 800,000 omits PD and uses LGD inconsistently.
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