CA Final · Advanced Financial Management · Risk Management
A bank lends Rs 50 crore to a manufacturing firm. The estimated probability of default (PD) over one year is 4%, the exposure at default (EAD) is Rs 50 crore and the loss given default (LGD) is 60%. What is the expected loss on this loan for the year?
Expected loss equals probability of default times loss given default times exposure at default. That is 4% x 60% x Rs 50 crore, giving Rs 1.2 crore. Ignoring the loss given default would overstate the loss at Rs 2 crore.
- ARs 1.2 croreCorrect
- BRs 2.0 crore
- CRs 0.8 crore
- DRs 30.0 crore
Explanation
Expected loss = PD x LGD x EAD = 0.04 x 0.60 x 50 = Rs 1.2 crore. Rs 2.0 crore ignores LGD (0.04 x 50), treating the whole exposure as lost on default. Rs 0.8 crore uses recovery rate 40% instead of LGD 60%.
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