FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment
A bank lends USD 5 million to a corporate borrower. The one-year probability of default is 2%, the loss given default is 45%, and the exposure at default equals the full USD 5 million. What is the one-year expected loss?
The expected loss is USD 45,000, found by multiplying PD of 2%, LGD of 45% and EAD of USD 5 million. Expected loss combines all three components, so using only PD times exposure would overstate the loss by ignoring recoveries.
- AUSD 45,000Correct
- BUSD 100,000
- CUSD 225,000
- DUSD 50,000
Explanation
EL = PD x LGD x EAD = 0.02 x 0.45 x 5,000,000 = USD 45,000. Ignoring LGD gives USD 100,000, which is the expected default amount, not the expected loss.
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