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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A bank lends USD 5,000,000 to a corporate borrower. The one-year probability of default is 2%, the loss given default is 40%, and the exposure at default equals the full amount lent. What is the one-year expected loss?

Expected loss is PD times LGD times EAD, which is 2% x 40% x USD 5,000,000 = USD 40,000. The USD 100,000 figure ignores loss severity and treats the whole exposure as lost on default.

  1. AUSD 40,000Correct
  2. BUSD 100,000
  3. CUSD 200,000
  4. DUSD 4,000

Explanation

Expected loss = PD x LGD x EAD = 0.02 x 0.40 x 5,000,000 = USD 40,000. USD 100,000 omits LGD (PD x EAD). USD 200,000 omits PD (LGD x EAD). USD 4,000 is a decimal-place error.

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