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FRM Part II · FRM Exam Part II · Credit Risk Management

A bank lends USD 10 million to a corporate borrower. The one-year probability of default is 2%, the loss given default is 45%, and the exposure at default is the full USD 10 million. What is the expected loss on this loan over one year?

Expected loss equals probability of default times loss given default times exposure at default. Here that is 2% × 45% × USD 10 million, which gives USD 90,000. Omitting the loss severity would overstate the figure at USD 200,000.

  1. AUSD 90,000Correct
  2. BUSD 200,000
  3. CUSD 450,000
  4. DUSD 4,500,000

Explanation

Expected loss = PD × LGD × EAD = 0.02 × 0.45 × 10,000,000 = USD 90,000. USD 200,000 ignores LGD (PD × EAD). USD 450,000 uses LGD × EAD without PD, and USD 4.5 million is the loss given default itself.

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